Weekly Market Commentary, April 1st 2008

Over the past two weeks I have had numerous conversations with clients about my view of the markets. Many have questioned why my mood has darkened recently. After all, I spent a great deal of time detailing why the January panic prices would represent the low point for the year, how pockets of valuation are appearing throughout the investment landscape and why widespread pessimism offered a key ingredient for a sustained rally. Have I abandoned my core beliefs and been overwhelmed by negative headlines? Am I reflecting the bearishness of Wall Street just when markets may be bottoming? Does not excessive monetary stimulus ensure that the bull will ride again? I have been wrestling with these and many other questions for the past few weeks.

Having spent the second half of 2007 in the bearish camp, I entered the New Year maintaining my view that an impotent Federal Reserve (Fed) would be unable to halt the economic decline. As each new rate cut failed to work, we witnessed credit markets tighten, the dollar plunge and commodity prices race ahead. To me, it was clear that the Fed’s actions were extremely inflationary. Since price inflation often leads to compressed multiples, any growth in profits would be offset by lower multiples and would push stock prices lower.

As the credit crisis worsened during January, both the Dow Jones Industrial Average (DJIA) and S&P 500 traded below my fair value targets. I took this as a sign that rationality had returned and that as an investor I was being compensated for taking on additional risk. Therefore, I gradually began to reexamine my market view and tried to determine if enough had changed during three weeks that a bullish stance would be reasonable.

Upon review, I was pleased with what I saw. Even though credit markets remained tight, by lowering interest rates aggressively the Fed was able to help consumers. Borrowers with adjustable rate loans were going to experience less payment shock than was anticipated a few months earlier. Minimum payments associated with variable interest rate home equity lines and credit cards dropped. The base rate on Option ARMS declined, thus reducing the negative amortization lenders had been accruing. While all of these items are modest, together they should make a difference. Borrowers who had been anticipating an ARM reset they could not afford would be spared. Homeowners using Option ARMs would avoid the negative amortization cap of their loan and be able to forestall the higher payments that accompany loans being recast. Over leveraged consumers would be given lower minimum payments on their credit cards. To me, we were laying the groundwork for consumers to maintain their homes, fix their finances and press forward.

Within this context recession appeared inevitable, but the severity was uncertain. With consumers experiencing less stress, I felt we would see a gradual bottoming in home prices. Even though prices had dropped, borrowers would be able to afford their payments, maintain the equity that existed and not be forced to push excess inventory onto a market that could not handle it. As long as employment remained strong, we could expect a mild slowdown that allowed consumers to repair their balance sheet and prepare for the future. Given this economic backdrop, the stock market would look through the recession and begin pricing the eventual recovery. Therefore, creating a diversified portfolio would allow one to increase their wealth as the markets recovered.

The expected recovery occurred quickly. Within nine trading days of the panic low, the DJIA and S&P 500 rallied nearly 7% and traded at a price that has not been bettered this year. As would be expected a quick rally created short term selling. However, the subsequent rebound to new highs never occurred. Over the next two months, the market would try on several occasions to push to new highs and failed each time.

What happened? Why did my economic scenario not allow the markets to push higher? As the Fed’s actions failed to unlock the credit markets, they responded in typical fashion. Interest rates would continue being lowered until lending resumed and the economy grew. Unfortunately, unintended consequences sabotaged their efforts. As interest rates were lowered, the dollar weakened. The lower dollar led to a decrease in purchasing power for consumers. Increased heating, food and fuel bills accompanied higher prices at Wal-Mart and Target. The cushion given by lower interest rates quickly evaporated under the stress of a weaker dollar. With credit markets closed for many borrowers, cost of living increasing and the employment market breaking down, an endless assault of negative factors hit the markets. As one could expect, failed rallies led to lower stock prices. As the DJIA failed to hold the lower end of its trading range, prices hit a low in mid-March before beginning their recent rally.

Given recent developments, I find myself where I started in January. With its recent actions, the Fed has adopted a mandate that all financial institutions will be saved and the printing press will run as fast as needed to forestall any adverse economic consequences. As James Grant notes in his recent newsletter, the Fed has adopted Depression era techniques to save an economy that has not officially entered recession and has unemployment near 5%. Ignoring the poor precedent and disregard for moral hazard, investors have been buying stocks aggressively. In fact, with the DJIA trading above 12,600 we have reentered the top of the trading range that has stalled us so many times before. Will the bulls finally break higher? Will the Fed finally find the perfect stimulus to save the economy?

While only time can answer these questions, I remain cautious. In 1950, total debt as a percentage of gross domestic product (GDP) was below 150%. In 2007, total debt as a percentage of GDP was over 350%. Over nearly 60 years, we have become a nation of debtors who rely upon borrowed money to fund incremental economic growth. Since the United States alone can print the money to retire the debt we incur, our economy has tremendous advantages. However, all good things eventually end. With a limit to both the debt level we can carry and the willingness of others to finance our lifestyles, monetary stimulus alone will eventually fail. The time will come when debt must be reduced, balance sheets restored and the nation returned to strong financial management. By pushing rates lower and flooding the markets with liquidity, the Fed is hoping to suspend the laws of supply and demand and buy their way out of the current financial crisis.

As always, the macro themes of the markets are interesting. However, my job is to determine ways to profit from these views. Given my overall view, three main strategies appear reasonable. The first would be to expect an economic slowdown and shift your assets to fixed income alternatives. This decision would be disastrous. With real interest rates negative and expecting inflation to accelerate, putting your assets into a bond portfolio would be disastrous. While you may be content knowing that principal will be returned and interest payments are predefined, wealth will evaporate. The second approach would be to become overtly bearish and short the entire market. I will admit that profiting while the market’s decline delivers a perverse pleasure. However, it is extremely dangerous. If one had taken a bearish stance 2 weeks ago, they would find themselves 5% poorer. Since many technical factors can work against short sellers, it is important to leave this game to professionals. The final choice is the one I advocate - develop a diversified portfolio of undervalued assets with high dividend yields that allow for both current income and future appreciation. A benefit of the current market chaos is that we can apply our research skills to find undervalued assets. As debates rage over the scope and need of various accounting methods, focused, diligent analysts can uncover hidden gems that will deliver strong performance in the future. In a market where I am wary about the future direction of broad market indices, I am using every hour I have to dig through financial statements and identify the stocks that will help my clients prosper over the coming years.

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