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Wedgewood PartnersWedgewood View 1st Quarter 2008: 100-Year FloodApril 30, 2008
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We ended the introduction of our last client letter, The Panic of 2007 and the House of Buffett, by writing in late January;
“… keep in mind – thus far, in 2008 this January has been the worst start for the market since S&P began keeping records 80 years ago… Expect more volatility and opportunity.”
Well. February and March wrought, and brought, both considerable volatility and opportunity. Amazingly, or numbingly, over half of the trading days during the quarter posted daily moves of 1% or more - the highest since 1938. More importantly, while the sharp spike in volatility certainly heightened investor angst, it also provided considerable opportunity – in spades. Like kids on Halloween night, we feasted our portfolios on quite a bit on goodies. But more on such treats in a bit.
Leuthold Group
Those who are familiar with our writings over the past year know that we had become quite bearish. The genesis of our worries began with the bursting of the once-in-a-generation housing bubble in 2005. Housing stocks and housing-related stocks certainly took it on the chin in 2006 and 2007. Our bearish stance was predicated on the view that after the U.S. housing stock bubbled to an astonishing spike to 153% of GDP in 2005, the deflating of the multi-trillion U.S. housing asset could not help but tip the U.S. economy into a recession. It has.
Furthermore, we held the view that the concomitant unwinding and de-leveraging of both the U.S. consumer and an assortment of financial institutions would take a considerable toll on the economy (recession), consumer spending (first consumer-led recession since 1990-1991 and corporate profits (negative year-over-year growth). Add all this up and we believed that a good ol’ fashioned bear market in stocks would be hard to avoid.
Financial markets are said to possess, according to the Efficient Market Hypothesis, taught in the B-schools in most of our illustrious universities and colleges, three “forms” or degrees of “efficiency.” The most stringent form states that share prices always discount and reflect quickly all information, public and private, and no investor can earn excess returns. This form reflects the view that markets are always “perfectly efficient.” We at Wedgewood carry the view that markets are usually efficient and that market participants are usually rational. However, there is a wide gulf between always and usually. Furthermore, there are moments in financial markets (which occur more frequently than financial market theory would suggest) when panic and passions rule. During such times, assets that typically are uncorrelated become brutally correlated. Fear becomes contagious. Selling (at any price) becomes the order of the day.
100 Year Flood
Being residents of St. Louis, Missouri, we saw first hand exactly what the phrase “100 Year Flood” truly means. St. Louis sits at due south of where the Missouri River joins the Mississippi River. During the late spring and summer of 1993, rain storms pounded the Upper Midwest. The magnitude and severity of this flood event was simply overwhelming, and it ranks as one of the greatest natural disasters ever to hit the United States. Approximately 600 river forecast points in the Midwestern United States were above flood stage at the same time. Nearly 150 major rivers and tributaries were affected. Rain-fall records were broken across the Midwest. Portions of east-central Iowa received as much as 48 inches of rain. Countless areas across the central-northern plains suffered precipitation 400% to 750% above normal. In our backyard, the St. Louis National Weather Service forecast area, encompassing eastern Missouri and southwest Illinois, 36 forecast points rose above flood stage, and 20 river stage records were broken. The 1993 flood broke record river levels set during the 1973 Mississippi and the 1951 Missouri River floods.
The Great Flood of 1993 was among the most costly and devastating to ever occur in the U.S., with $15 billion in damages. The hydrographic basin affected covered around 745 miles in length and 435 miles in width, totaling about 320,000 square miles. Within this zone, the flooded area totaled around 30,000 square miles. To put the size of the 1993 affected flood basin in perspective, Lake Superior is 31,820 square miles in size and all five of the Great Lakes combined are 94,250 square miles in size.
100 Hour Flood
As we outlined earlier in this letter, (and to torture the flood metaphor a bit), housing and debt “rain” has been steadily falling on the U.S. consumer, financial institutions, the U.S. economy and on Wall Street since 2006. It began to pour last summer. Bulls and bears had quite the tug-of-war during the first half of 2007. As generation-high for-sale supplies of new and existing homes cratered residential prices, the bull’s position that the mortgage contagion would be contained to just the mortgage sector began to unravel by late summer.
As strong as the mighty U.S. economy is, the unending news of mortgage foreclosures (current rate: 7,500 per week), collapsing U.S. consumer confidence and the growing list of financial institution triage (Countrywide Financial, Fannie Mae, Freddie Mac, Citigroup, MBIA, Ambac, UBS Financial, MGIC Investment Corp., Washington Mutual, Merrill Lynch, Lehman Brothers, AIG, CIT Group, National City, Sallie Mae, Wachovia… ad infinitum ad nauseum) reached a crescendo in mid-March.
Bear Stearns Abyss or Bear Stearns Bottom
The stock market experienced a 100-Hour Flood during the second week in March when Bears Stearns evaporated in 100 short, brutal hours. Bear Stearns has a long and storied history, yet during the firm’s last dozen years of its 84-year history it has morphed into a (sad, tragic) caricature of the financial times – astonishingly leveraged at an asset-to-equity ratio of 35 times. As if such debt leverage was not enough, too much of Bear Stearn’s assets were a witches brew of toxic, illiquid mortgage securities. But the worst was the firm’s $13 trillion book of derivatives. Of course, derivatives positions are usually balanced and hedged, but just as bank depositors’ fear can set a run on a bank, customers and clients…and derivative counterparties, can set a run on an investment bank.
To a large extent, the primary objective of an investment bank, such as Bear Stearns, is to provide liquidity to various markets. Bear Stearns and many others were remunerated – handsomely, it seemed, until recently – for providing this liquidity “service” to the market. Richard Bookstaber’s 2007 work, A Demon of Our Own Design, decants the supposed sophistication inherent to this risk-taking process, remarking that investment firms (he uses LTCM as an example) typically rely on simple historical information to model their risk. Furthermore, as Bookstaber points out, “firm’s risk models look at past price variability and provide the…assurance that they [can] survive the financial equivalent of the 100-year flood.” And here is the kicker that Bookstaber provides, “the problem was that their models assume they [are] in a ‘game against nature’ where their decisions do not alter the playing field...But as [one of] the largest players in a world of looming illiquidity, this worldview was naïve at best. Their actions did change the game, because the decisions of other traders would change depending on the actions or perceived actions (of Bear Stearns – for the sake of this argument).” Bookstaber concludes his thoughts by citing John Merriwether’s (the formal principal of LTCM) post-mortem note to investors that read: “The hurricane is not more or less likely to hit because more hurricane insurance has been written. In financial markets this is not true. The more people write financial insurance, the more likely it is that the disaster will happen because the people who know you have sold the insurance can make it happen.”
The evaporation of both Bear Stearns’ corporate liquidity and the fleeing of client assets were indeed like a flash flood during the firm’s last desperate 100 hours. So worrisome that U.S. and global markets’ (stock, as well as debt and money markets) were at great risk of seizing up, if not a pure meltdown had Bear Stearns filed for bankruptcy, the Federal Reserve and the U.S. Treasury would take unprecedented, historic measures to “bail-out” Bear Stearns.
Philip Graham, the former editor and co-owner of the Washington Post has been credited with calling journalism the "first rough draft of history." A debate has ensued whether Bear Stearns’ clients and counter-parties were truly at risk. The complete history of the meltdown of Bear Stearns will be written in due time, but we are under no illusions that we have not entered a new era where once “too-big-too-fail” was the order of the day and the new order has become “too-interconnected-to-fail.” We will never know; but we suspect that in a previous era, the markets’ could have handled a failure of a financial institution the size Bear Stearns. But as we have written (and spoken) unceasingly over the past couple of years, the current era is like no other. We do now know that at the 11th hour, the Federal Reserve pulled a previously offered 28-day non-recourse loan to J.P. Morgan (secured by the most toxic of Bear Stearns’ mortgage debt) over that fateful weekend in March, thus sealing the J.P. Morgan/Bear Stearns shotgun-marriage.
When news hit of the collapse and bail-out of Bear Stearns Sunday evening, March 16th, foreign markets reacted as expected with sharp sell-offs. U.S. stock market futures fell sharply as well. When Monday trading began, many were braced for the worst. But…remarkably…it didn’t happen. Sure, some financial stocks initially got hammered (Goldman Sachs), but the markets RALLIED!
Contrary opinion, as an investment philosophy, states that the “crowd” is typically wrong. A corollary of such views is that collective investor fear (and greed), at extremes, is often wrong. Such was the case, we believe, during the stock market plunges in January and March. Yet, at times, the “collective wisdom” of crowds can be spot on. The market correctly, and, in our view, came to the rapid conclusion that the Bear Stearns bail-out signaled that the Federal Reserve, the U.S. Treasury, and yes, our laissez-faire Administration would not permit a systemic market melt-down. The fear of the “un-known” was eliminated. Stock market investors could once again focus on the prospect of “knowables;” i.e. individual corporate fundamentals.
A Bear becomes a Bull
Our call for a classic bear market has come to pass (-20% intraday market decline from October ‘07 highs to January ’08 lows). But much more importantly were the severe bear market declines that took place in individual stocks. As we mentioned, as market fears became palpable during the first quarter, we truly became like kids in a candy store. We no doubt had one of our busiest quarters in memory as the market served up fat pitches in Apple, Cognizant Technology, EMC, Express Scripts, Google, Goldman Sachs and Whole Foods Market. Our additions to these stocks have served to make them among our portfolios’ largest holdings.
So, do we really think all is well? No…not hardly. Of course, only time will tell, but while we believe that the markets have discounted the potential-worst news; we have many bumps and potholes ahead of us. Namely:
Investech
Furthermore, as we have written exhaustively, corporate profits still face long headwinds from a slow economy, a weak consumer and shrinking margins.
We believe we have entered into a new period of corporate “have” and “have-nots;” witness the poorer-than-expected earnings from General Electric and the better-than-expected earnings from IBM. Internationally-derived earnings continue to be a bright spot. Please note: in our current portfolio only two companies derive their respective revenues in whole or largely from domestic sources only: Express Scripts and Whole Foods Market.
Leuthold Group
Continuing the theme from recent Wedgewood View. letters and our 2008 Outlook (and talking our book), we still believe the current macro environment favors Large Cap Growth stocks:
Legg Mason Capital
Markets do their best to surprise (and disappoint) the many. We may well look back upon the years of 2007-2008 and recall a “career” buying opportunity in Large-Cap Growth stocks.
In summary, while we have become much more bullish, significant concerns remain. The U.S. economy is in a recession and we doubt it will be a short recession. It will take years for the U.S consumer to de-leverage and repair their respective household balance sheets.
Just as there are corporate “have” and “have-nots,” investor “haves” are sitting on record cash levels. Such levels certainly speak to extremes in investor pessimism – which contrarily, is quite bullish.
According to Investech, even the inflation bogeyman could be just that if the history of recessions extinguishing inflation is any guide.
Corporate earnings will likely be a mixed bag for some time to come. At the start of the year, first quarter consensus earnings estimates for the S&P 500 were +12%. Analysts have slashed (finally) expectations to -1%, yet full year 2008 estimates are still a remarkably bullish +15% - hope springs eternal on Wall Street. Yet, as mentioned, the bright spot continues to be those companies who derive meaningful international revenues.
Again, and most importantly, our invested companies are decidedly beneficiaries of strong international growth. We certainly expect our portfolio of double-digit growers to shine in the current challenging environment.
David A. Rolfe, CFA Dana L. Webb, CFA Michael X. Quigley, CFA Chief Investment Officer Senior Portfolio Manager Portfolio Manager April, 2008 The information and statistical data contained herein have been obtained from sources, which we believe to be reliable, but in no way are warranted by us to accuracy or completeness. We do not undertake to advise you as to any change in figures or our views. This is not a solicitation of any order to buy or sell. We, our affiliates and any officer, director or stockholder or any member of their families, may have a position in and may from time to time purchase or sell any of the above mentioned or related securities. Past results are no guarantee of future results. (c) Wedgewood Partners |
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