1/01/08 –


On 12/31/07 the S&P 500 closed at 1468, resulting in a total return of 5.49% for the year, and undervalued by 39% on an error correcting basis. One year ago, the undervaluation was 46%. We are cautiously invested in non-cyclical equities, below our normal equity target. We are assuming that the U.S. will fall into a moderate recession in 2008, slowing economic growth compounded by the credit crisis.


Market Analysis


If there is a recession, the U.S. stock market will follow the economic fundamentals downwards. We are not going to buy the dips; we think that waiting for the stock market to stabilize at a lower level, as the credit markets resolve their various problems, will be a better course.




The economic problem in the headlines is, of course, the subprime mortgage problem and its effect on broker/dealer writeoffs, at both the specialized firms and the major international commercial banks. Assuming a 10% drop in home prices from the peak and using OECD and a Street assumption, we estimate that the total writeoffs of three problem assets: subprime mortgages, their derivatives, and specialized investment vehicles at the ten largest broker/dealers and commercial banks could be $130 billion1, or 24% of the industry’s $550 billion book capital in August. This estimates the permanent loss of capital to the existing shareholders of these companies. All other issues aside, the government sovereign wealth funds now providing some of the replacement capital will demand more conservative business practices.


This analysis suggests a general direction and a reason for our caution. A continued drop in house prices would have a continued negative effect upon the rest of the economy and on other loan assets.




The subprime problem more generally affects credit creation. Central to the nature of this financial crisis is the concept of credit that enables the banks to finance real GDP growth.


Under the traditional fractional reserve system controlled by the Fed, the depository banks used their deposits to make loans, withholding a fraction of their deposits at the Fed. The amount of credit the entire banking system could create was thus limited. In the last decade, this system has broken down as the ever inventive capitalist economy created new forms of credit to finance transactions, not under the control of the Fed. The banks sold their commercial and subprime loans to other investors and to structured investment vehicles, funded in the short-term commercial paper markets. They could then make more loans from the same deposit base.


Since the shutdown of the structured finance and commercial paper markets, unmarketable mortgages and returning commercial loans have increased the loan assets at the commercial banks, securitization in reverse. According to Fed statistics, between 10/06 and 10/07, the largest U.S. commercial banks expanded commercial and residential loans by 11.4%; but probably including writeoffs, their book net worth expanded only by 2.6%. This process of involuntary lending cannot continue at that rate. Additional writeoffs will impair the commercial banks’ ability to expand credit to the rest of the economy, their net worths affected by both direct commercial and real estate subprime loan losses, and structured finance losses.


Some say that the effect of these losses on the banks’ ability to create credit will be around 10X these writeoffs, in this case $1.3 trillion or more than 9% of GDP. Due to the profitabilities of the banks’ other non-subprime businesses and foreign capital investments, we think the impact of these writeoffs will be less drastic – but there will be an effect. OECD writes, “(these writeoffs) would lead to some periods of instability in the credit supply process.”


Portfolio Strategy


Equity investing requires optimism, but the basis for that optimism must be realistic. We think that a recession is already baked into the cake by currently large imbalances, in real estate supply and its financing. We have invested mainly for income; there is nothing wrong with being paid to wait. The stock market will have to meet two value criteria and, admittedly, one technical before we increase our asset allocation to common stocks. At some point, the markets will begin to resolve their widespread credit problems with increased transparency and reduced complexity.



1 As of 12/20/07 these firms have announced, or Wall Street has estimated, $62.0 billion in third and fourth quarter structured finance writeoffs.



1/22/08 –


The S&P 500 has dropped 10.7% since the beginning of the year to 1310. Other markets abroad extended their losses for the year as investors abroad saw increasing unknowns in the U.S. and the world economies. The general reaction has been to head for the lifeboats.


Since we are value investors, making a distinction between market prices and a permanent loss of capital, we certainly don’t see lower prices as a reason to sell. But neither are presently decreasing prices any particular reason to buy. We don’t think that housing prices, bank loan portfolios, and the U.S. stock market have bottomed. Keynes wrote, “In the main…slumps are experiences to be lived through and survived with as much equanimity and patience as possible.”



2/1/08 –


Why do business downturns occur? Since the economy fluctuates, business downturns occur because there are business upturns. As is obvious this time, a business downturn will error correct the excesses to which the capitalist economy is prone.


Over the years, the market economy has developed sophisticated institutions. The Fed, however, can only ameliorate recessions. It cannot eliminate them due to the error correcting nature of markets and to the decision maker’s imperfect information *. The Fed’s likely strategy under these conditions is to stabilize output when inflation is low and then aggressively hike rates when the economy-wide expectation of inflation begins to increase.


Unfortunately, this cycle, two of the three major monetary policy channels for stabilizing output are not effective. Early cyclical real estate is in excess, and consumer debt is at an unsustainable level. That leaves only business investment, which currently remains high but could also drop. The Fed’s strategy is to lower rates rapidly to do what it can to stabilize output; the dollar will suffer the consequences until the rest of the world also starts cutting rates. The use of fiscal policy to stimulate the economy is limited by the budget deficit.


The U.S. and, perhaps, the international economies are in for a bumpy ride. Patience is a virtue while the economy clears the stage for future growth by the necessary current writeoffs ** and perhaps by a government program.



* This Fed article is in mathematics. A decisionmaker with a “quadratic loss function” is happiest when results are on target, and less happy when results deviate from that.


** This AICPA accounting bulletin raises some interesting issues. Benjamin Graham’s Mr. Market now mandates large subprime writeoffs, having previously signaled a large investment. Could the whole subprime problem have been avoided in the first place by being somewhat rational over the long or even medium-term? The information then available to do this was not imperfect; it was almost causal.





An authority on the subprime debacle recently spoke. The problem was not the general irrationality of the market, but the short-term hyper-rationality of the borrowers (who were given the money by lax lenders), the investment banks (that sold the CDO paper to earn their fee, and got caught when the music stopped), the rating agencies (that sold their AAA rating for a $600,000 fee on a transaction that closed, rather taking a $25,000 inspection fee for saying “no”), and finally hypo-rational investors who relied upon the rating agencies to rate their opaque and confusing tranches.


The sum total effect of this long chain was irrational market behavior in the short-term. In this chain of woe, a healthy investor skepticism would have resulted in a more rational credit market, requiring less error correction. In the long-term no one was rational – that is, considered the consequences of their actions. Borrowers got houses they couldn’t afford; the financial companies degraded their franchises; and investors lost their capital.


It is not possible to control risk without also considering the underlying investment fundamentals. In finance, it is possible to be too smart. The pyramids of financially engineered paper: the CDOs, CDO2, CDO3, and credit swaps are now collapsing. To mix a metaphor; as the environment changes, these layered icebergs are now crashing into an opaque sea of market illiquidity. We remember seeing a television show about global warming; when the icebergs are crashing, its better to be cautious.



3/1/08 –


Will the recession look like a “V”, a “U”, or a “L”? This could affect a decision to increase our asset allocation to stocks. To say, for instance, that the economy will recover by midyear assumes that this recession will be mild like the ones of the recent past, and that the recovery will look like a “V”.


We have analyzed the consequences of a mild recession upon financial company earnings. What will be the actual recession’s duration? Its going to take a while. The recession’s causes are housing related, it is becoming widely consumer based, and the credit structures seizing up the financial markets are very complex. What began as a somewhat limited subprime mortgage problem has now become a pervasive structured finance problem *. At a G7 meeting on 2/9/08 Fed Chairman Ben Bernanke was quoted as saying that while housing prices are falling, it is not possible to determine how long and deep this crisis will be. We think that targeted measures to stabilize the housing market are necessary for the financial system, with all its complications, to recover. Government efforts should be focused directly on the housing problem. From congressional testimony on 2/14/08, we sense that the lawmakers and regulators are very concerned with this financial crisis.



* There was a fundamental credit flaw in many structured finance investments. The constituent subprime loans did not have cash flow margins of safety. Mathematics and statistics imply precision, making packages of risky loans appear as safe ones. Investors were not aware of the difference between simple statistical distributions and reality. Very good events or bad events can also happen.


Economics is a social science. Peter Bernstein observes that Nobel laureate economists disagree on where the border between theory and reality lies, not on the theory. In 1921, the economist Frank Knight made a crucial distinction between risk and uncertainty. Risk is when the distribution of the alternatives can be calculated a priori or specified from historical experience; uncertainty is when it can’t be, because the instances are to a high degree unique. 


To make decisions about events you have to know the specifics of what’s happening, rather than the operation of some statistical law. That’s why judgment and a long-term margin of safety, just in case, are good ideas.       




This website is about the stock market, financial markets in general; and thus about human behavior. Markets are places where people come to buy or to sell based upon price. That requires information about the merchandise on sale; consider how customers inform themselves in open-air markets. The root of the word “credit” is the Latin word “credere,” to believe. Markets do not function if there is no informed belief because there are simply no buyers, as is presently happening in the credit markets. Many structured finance investments having become incredible, investors are hunkering down, guarding their capital.


House prices continue to decrease although the Fed has cut short-term interest rates. A problem, Professor Peter Morici of the University of Maryland points out, is that the mortgage business model is broken. Most U.S. house mortgages are privately financed, bundled into securitized packages. It is no longer possible to get these packages funded in the markets. He suggests the Fed chairman should have a good talk with the banks about the viability of the business model that created these unintelligible, complex securities.



3/22/08 –


We left for a trip on March 7th , when the S&P 500 began to tumble below 1260. We returned on March 20th, when the S&P 500 rallied to 1329. Does this volatility, full of sound and fury, signify nothing?


We don’t think so. The market is volatile because it is grappling with uncertainty, when the macro outcomes ordinarily assumed to be stable, cannot be clearly known *. This steadily morphing credit crisis began last August, imperiling overleveraged financial institutions and creditworthy borrowers alike, the exchange rate of the dollar, and ultimately the real economy. In a 3/13/08 Financial Times article, Mohamed El-Erian, PIMCO’s co-chief investment officer, writes that the stock market and the credit markets will have to converge, and “the longer the delay in strengthening the (housing) policy response, the greater the likelihood that such convergence will involve share prices falling to levels implied by the debacle in credit markets.” This means that there is only so much time for government to act.


The problem facing both the credit and stock markets is falling house prices, that continues to erode the pyramid of financial paper that derives its value, in some form, from housing. All economic downturns have their differences. Since the 1930s, previous financial crises have been localized and localizable, limited to the failure or bailout of financial companies that became overextended and to the S&L industry. This downturn is unfortunately characterized by its pervasiveness, the result of large-scale lending without considering the ability and willingness of borrowers to repay their loans and a lack of external regulation, a major downside of world-wide market securitization. As house prices continue to fall, the financial system will continue to experience recurrent crises until the government steps in to enable the orderly writedown of roughly $2 trillion in subprime and Alt-A mortgages and the housing stock. Housing prices and mortgage debt service must ultimately fall to levels sustainable by consumer income.


Our next article will discuss how current stresses reveal the nature of markets.



* We speak, for convenience, about “the market.” It is usually more useful in financial analysis to ask what people are actually doing. A 3/25/08 NYT article states well what is actually happening. “The violent  (market) swings indicate that traders are seizing on daily events to jump in – or out – of the market, grasping at clues about where the economy is heading. A result is a jittery, bewildered pack of investors (actually traders, who act with and at the margin) whose mood can quickly swivel between fear and optimism.”  



4/1/08 –


A present S&P 500 level of 1370 assumes only an inconsequential economic slowdown, with expected capacity utilization remaining around 82%. We think the stock market does not reflect worsening economic conditions due to bank lending problems. Iraq also doesn’t help.


There seems to be a convention when anticipating a change for the better, just wait six months. Recall the serial predictions by foreign policy makers about an improvement in Iraq, in six months. Consider now the current wisdom that the economy will begin to recover in six months after the beginning of the slowdown in January. There is a gaping logical disconnect between assuming that less than half of the bad loans have so far been written off (according to one Street estimate, the total writeoffs by the U.S. leveraged financial institutions will be at least $460 billion), and then assuming a rapid cyclical economic recovery. A greater economic slowdown would compromise more consumer credit than residential mortgages.


Both the problem in Iraq and in the financial markets have become very large and complex. Their solutions require much more than ideological simplicities and finger pointing. An opinion already exists on Wall Street (on the buy side) that the investment banks have to be subject to real regulation if they are to be given any access to the Fed’s discount window. A 4/1/08 FT article indicates that global policy makers remain very worried about the condition of the financial system and are thinking about temporarily suspending capital requirements and in “assisting financial institutions in remaining as going concerns.”


At a minimum, this means that the financial companies will have to be more careful about the merchandise they sell *, as ought to be and is generally true in business.



* A major question is how to value those subprime structured mortgage concoctions.


Consider a simple bank loan with a cash flow margin of safety. The value of this loan can be calculated relatively simply by discounting the present value of future contracted cash flows, to be paid as agreed. Now add a simple structured finance complication. Slice that investment into tranches, the first tranche has a cash flow and collateral priority. Within the finance structure, its like debt and should have a higher credit rating than the following tranches. Does it ever warrant a AAA credit rating like some of the subprime mortgage tranches? It doesn’t because the credit rating of the highest tranche should be the credit rating of the loan. Since a defaulting loan almost inevitably results in a very large writeoff, not to put too fine a point on this, the subordinate claims will have almost no value.


Does “diversifying” the portfolio help matters, packaging many borrowers into the financial structure? It could, but only if the loan outcomes of all borrowers are truly independent. If subprime loan performances depend on a single factor like the state of the economy, then all those loans can be regarded as a single mistructured loan whose performance depends on the state of the economy. Taking the example we discussed on 3/1/08, 94.3% of all tranches are rated AAA; only 5.7% of all tranches are rated below that. To draw an analogy, this structured transaction does not contain enough “equity.” What is a senior tranche worth?


The current market apparently assumes worse. The AAA tranches of the notorious 2006-2007 vintage of subprime CDOs trade on average around 68 cents on the dollar. More generally, current Street estimates of total subprime real estate loan losses run around $230 billion, with about 80 cents on the dollar remaining. However, from our 1/1/08 analysis, this implicitly assumes residential real estate prices do not deteriorate much further from current levels.


Since house prices continue to deteriorate badly, there is a role for government to enable an orderly writedown of prices to levels where borrower income can support restructured mortgages. That’s the core of the credit problem . A lot more is at stake than the doctrinaire quibble that the government shouldn’t help irresponsible borrowers.



4/11/08 –


GE just reported its first quarter earnings; the S&P 500 dropped by 2%. The company is a bellwether of the U.S. economy. In comparison with the previous year’s first quarter, the operating profits of the company’s infrastructure business (that sells exportable capital equipment to the utilities, transportation, oil & gas industries) increased by 17%. GE’s finance businesses decreased by 19%. The company’s industrial business (such as appliances) decreased 16%.  Overall, the company’s operating profits decreased by 4.2% from the previous year. The U.S. economy, accounting for around 25% of the world’s GDP, is slowing down.


We think the present economic environment justifies an extreme degree of caution. A 4/08 IMF Global Financial Stability Report writes that their analyses, “point to a degradation of financial stability, with credit and macroeconomic risks having deteriorated the most.” They analyze the impact of restricted credit upon the U.S. macroeconomy: In the postwar period, credit has grown on average by around 9% of private sector debt per year. What if, due to the financial shock of lender writeoffs, annual credit growth were reduced to 4% and 1%, respectively? The slowing of credit growth to 1% is comparable to that experienced during the comparatively severe 1990-1991 recession.


Using an econometric model that includes real GDP growth, inflation, private sector borrowing, and interest rates between the first quarter of 1952 and the third quarter of 2007, and assuming no other shocks to the system, the analysis shows that in either case, the effect of credit stringency will continue to dampen growth well into 2009. We consider this a base case. The analysis, however, also lists the following other factors:


1)       Unusually aggressive monetary policy easing by the Fed. (It’s doing only some good.)

2)       The impact of slowing credit growth upon the European economies.

3)       The securitization of questionable financial assets at the heart of the banking system, causing many system complications.

4)       We add: further large loan losses that are comparable to those of the Japanese banking crisis of (1990-1999).  


This financial crisis began as a subprime problem. It is now a generalized credit problem placing pressure, as the IMF states, on systematically important financial institutions. The next article will discuss our portfolio strategy in this environment.



5/1/08 –


The IMF and other sources (e.g. Morris, (2008)) estimate total credit writeoffs of around $1 trillion (2007 U.S. GDP was around $14 trillion). Goldman Sachs estimates that U.S. financial institutions could lose around $460 billion. They have so far written off around $134 billion (Lehman, 4/08, U.S. estimates). Housing prices continue to deteriorate. There are more writeoffs on the way.


The Bank of America is the nation’s largest domestic bank. We track the company’s loan portfolio because it indicates what is actually happening. The bank had not been in the subprime lending business. Nonetheless, it has charged off $8.7 billion in mainly subprime trading assets since the middle of 2007. It recently raised around $13 billion in new capital; its accounts ought to be squared away with a total net worth of $156 billion at the end of March, 2008.


The problems lie with the bank’s regular businesses. In one quarter, its non-performing loans rose by $1.9 billion or 31.5%, presaging increased chargeoffs. A major problem is the banks’ contraction of lending to the consumer sector of the economy. During the first quarter, total consumer loans (including mortgage, home equity, and credit cards) dropped by $6.6 billion, or 1.2%. Corporate lending rose somewhat, but the bank’s total loans declined by $2.5 billion, or .28%. Referring to the recent IMF study, a U.S. lending growth rate of 1% per year is a severe restriction of credit.


Excesses at the lending level crashed the credit markets and their derivatives. It does not require rocket science to deduce that the resulting writeoffs and credit constrictions will have their unfortunate effects on the real economy. Although the S&P 500 closed at 1409, we are not chasing this stock market rally.



6/1/08 -

A combination of the Fed’s willingness to rapidly liquify the financial system and the access of U.S. financial institutions to foreign capital has so far prevented a system-wide financial crisis. The stock market and S&P expect a rapid economic recovery. Operating earnings of the S&P 500 are estimated to increase 8.3% in 2008 (that is with all the financial writeoffs) and further increase 23.4% in 2009.


The following possibility, however, seems more likely. The economy must correct the large imbalances that have been developing in the past years. The economy’s industrial capacity utilization rate has dropped from about 81% several months ago to 79.7%. In a recession that figure typically bottoms out at around 74%-67%. According to the 3/08 S&P/Case-Schiller Index, the decline in U.S. house prices continues to accelerate.


The error-correcting U.S. economy is one of the world’s most resilient; it will eventually generate new investment opportunities. Current credit errors are, however, very large. It would be very optimistic to assume that they will have no effect. We remain very cautious, as housing prices and leverage continue to unwind at their paces. What began as real estate and financial crises is now beginning to affect the rest of the economy.





Stocks are, by nature, long-term assets with (roughly speaking) dividend payback periods of 15-20 years. The evaluation period you choose to allow events to play out is crucially important. For us, its around one or two years; for leveraged traders its day-to-day. Trading is also caused by investors that have different time horizons. We spoke with a mathematical economist who said, somewhat theoretically, that investors differ by the information sets they use.


For example, if your evaluation time horizon is about six months (probably the same as the stock market's) you could look at present low interest rates, tax rebates, and conclude (based upon experiences before 2001) that the economy and the stock market will recover by the middle of the year. On the other hand if your evaluation time horizon is longer than that, you could make a judgment that because housing is such an important part of the economy, a decrease in house prices will have bad effects. Furthermore since the financial sector does matter, the resulting writeoffs will cause credit restrictions, further pulling the economy down. These events should play out over the next year or so, because real estate crises tend to unfold slowly.


Reasoning based on the former would result in a high stock allocation. Reasoning based on the latter would justify a defensive portfolio policy. By temperament and training we invest according to the longer evaluation time horizon, but find shorter time considerations interesting. A noted bank analyst writes, “The real harrowing days of the credit crisis are still in front of us…and will prove more widespread in effect than anything yet seen.” We would say that investors should be very cautious.





If you wonder where those billions of dollars of structured finance writeoffs came from, read on. A 5/21/08 FT article reported:

That one error in a line of computer code gave nearly a billion dollars of securities ratings up to four levels above the usually calculated. Maybe the ratings formula should have been ... X*2 rather than X^2. S&P, on the other hand, admits to no problems with their ratings model that gave similar marks; however, it is subject to revision.

Billions of dollars of fly-by-wire deals were controlled by undebugged computer code, inconstant computer models, and they were sometimes based on structured products that were used to fund other structured products. Not surprisingly the whole misconception crashed. The early Enlightenment assumed the exact calculability (in principle) of everything, including society. The late Enlightenment discovered that knowledge is continually developing. This is the current general view in academia. The problem with quantitative finance is that it produced fixed income contracts that did not have the margins of safety that allowed for the unforseen and undefined, and it produced contracts based on the ephemeral. Judgment is always necessary.

* It was more convenient for the sponsors to create securities based upon derivatives than for them to assemble actual loans. Not that the actual loans were necessarily sound. On 5/23/08 Fortune magazine reported that some asset backed portfolios, containing primarily auto and credit card loans, would be generously valued at 50 cents on the dollar.


6/11/08 -

The S&P 500 continued its drop to 1335.

A combination of the effects of the credit crisis (affecting operating earnings) and the inflationary effects of oil and agricultural supply shocks (affecting long-term interest rates) is not good for the stock market. We reiterate our cautions and hope our readers have already sold down to their comfort points.

During times of supply shock, contrary to the theoretical Philips curve, it is possible for capacity utilization to decrease and for inflation to increase. Modern monetary policy emphasizes vigilance about the state of expectations.


7/1/08 -

The S&P 500 dropped to 1285. The 4/08 S&P Case/Schiller index of house prices continues to decline. If you read this report, you will notice that the price decrease in the 10-City composite has become identical to that of the 20-City composite, a characteristic of general market turmoil when whole asset classes are called into question.

It is estimated that all the major financial companies have so far charged off $397 billion, with chargeoffs to total at least $1 trillion over time. This will have the very unfortunate effect of vastly eroding their net worths. The result, as in all major financial crises, will be the necessary deleveraging of the financial system. We doubt this process will occur at all smoothly. Structured finance further globalized the financial markets, but the widespread products had three major flaws:

1) The Gaussian pricing models were an inaccurate representation of real markets (as we have been insisting), understating the risks that might occur if continuous trading markets disappeared due to the influence of events and the complexity of many structured products.

2) The structured finance products were misrepresented to investors looking mainly for safety.

3) The products were badly implemented. On 6/23/08, Cnn reported that an University of Iowa study found, in the process of slicing and dicing house mortgages, the lenders had lost 40% of all the promissory notes. Many properties are into the foreclosure process with the loan servicers unable to provide proof of indebtedness. There can be as many as eleven different parties involved in securitizing a single mortgage.

This whole financial crisis is about misconception, misrepresentation, extreme complexity and a lack of attention to the details. Bank loans are usually, as a journalist wrote, "gnarly." They are configured to each borrower's unique situation with covenants, guarantees, and a specific financial structure. These necessary protections act against the uniformity that markets and marketability require. It should be noted that the generally successful GNMA and FNMA mortgage securitizations carry implicit government credit guarantees.

It is in the nature of a value investor to be nervous when stocks approach their equilibrium values and to consider investment opportunities when stocks approach their lower purchase targets during difficult market moments. But the credit problems of the financial system are very extensive. We will begin to purchase stocks when a number of them are at or below our purchase targets and when house price declines show some sign of abatement, knowing that value investing requires patience. This statement has nothing to do with picking a stock market bottom under conditions of turbulence; that is not possible.


How will the financial industry restructure? It will probably evolve away from producing complicated securitizations. Credit within the financial system can be allocated either by the markets (via the investment banks) or by administration (via the pure commercial banks, as is the tendency in Europe). It is obvious, the markets - not to put too fine a point  this - have made very large mistakes in resource allocation, because they overreacted.

What started as a fairly theoretical discussion of market behavior has now very real consequences. The necesssary adaption of U.S. businesses to foreign markets has been delayed, consider the trade deficit. The economy has created millions of non-exportable empty houses and mountains of untradable paper, while the real problems of society in the areas of infrastructure, education, research, and health care remain or worsen. This is the result of unregulated market fundamentalism. The markets have to be intelligently regulated.


7/10/08 -

Is the 4/08 IMF estimate of $1 trillion in credit writeoffs excessive? A recently published SEC report suggests an answer.

The three major credit agencies: S&P, Moody's, and Fitch made possible the securitizations of structured finance by giving subprime mortgage securities high credit ratings. On 8/07 the SEC commenced a study of how these agencies complied with the requirements of their registration with the Commission, the SEC explicitly not regulating "the substance of the credit ratings or the procedures," but their retention of records and their management of conflicts of interest. However, this polite but critical report comments on all these areas. What emerges is the genesis of a very large problem that became manifest with a crisis in the $640 billion (2006) subprime mortage market. These problems are now spreading to the slightly higher quality Alt-A mortgage market, the derivatives associated with both, leveraged corporate loans, and to the other debt obligations of the general economy.

SEC examiners reviewed the deal files, internal audit reports, and (by automated means) examined more than 2 million e-mails and text messages. The resulting report makes these major points:

a) None of the agencies had specific written procedures for rating RMBS (subprime residential mortgage securities) and CDOs (collateralized debt obligations). The structured finance ratings process was "inherently flexible and subjective." At one firm, an analyst expressed the opinion that the ratings model did not capture "half" of a deal's risk. This, we might add, was for investments that were sold as being precise and scientific. An analytic manager wrote, "the rating agencies continue to create an even bigger monster-the CDO market. Let's hope we are all wealthy and retired by the time this house of cards falters.'"

b) The ratings agencies made "out of model adjustments" (guess in what direction) and did not document the rationales for these adjustments.

c) The ratings agencies do not appear to have specific policies to identify or address errors in their models or methodologies.

d) The SEC could not "assess compliance with ...established policies and procedures, and to identify the factors that were considered in developing a particular rating....There was also a lack of documentation of ratings committee actions or decisions...there was sometimes no documentation of committee attendees."

e) One agency allowed their senior analytical managers to discuss fees with issuers.

f) Since the arranger often designs the deal, he has the flexibility to adjust deal structure to obtain a desired credit rating, as compared to arrangers of non-structured assets...arrangers that underwrite (structured finance) offerings have substantial influence over the choice of rating agencies hired to rate the deals." The structure of the deal determines the price of the package, and thus its profits.

g) The actual ratings models used were incredibly complex. "...while RMBS default probability and loss severity ...models required 50 to 60 (sic) inputs, CDO models required only five inputs: current credit rating (of RMBS securities), maturity, asset type, country and industry." Unfortunately the CDO models used the credit ratings previously discussed.

The detail provided by this SEC examination allow us to reach several conclusions:

1) Given the magnitude of the ratings problem, an IMF 4/08 $1 trillion estimate in ultimate writeoffs is not excessive. Our 5/1/08 comment provides further details.

2) The stock market peaked on 10/07. Credit problems began to occur some years ago; but investors reacted late because the mortgage backed securities, rated AAA, were often a single line item on the notes to the financial statements. Markets do eventually ferret out the truth, but then it may be too late. It pays for investors to be alert to developing troubles when the skies are clear and times are good, and to know what they don't know *

A value investor also tends to sell during those times, simply because a stock would likely be overvalued.

3) We wouldn't want to buy stock in the rating agencies for a long time.

The SEC report describes the lending controls that are necessary to keep money from being shoveled out the door **. The report leads to the conclusion that these controls broke down. The problems *** of structured finance are both very broad and deep, thus a role for government.


* add: The 7/18/08 Washington Post writes, "Do market fundamentals usually prevail in the long run? Of course....(but) these fundamentals can take years to finally assert themselves -- on the way up as well as on the way down. It is during those periods of irrational exuberance and panic that so much damage is done (because financial markets are imprecisely error correcting rather than mean reverting), both by those participating in the markets and those who are supposed to regulate them."

** add: The 7/20/08 NYT suggests the method behind the madness of shoveling the money out the door, with little consideration of loan repayment. "...behind the big increase in consumer debt is a major shift in the way lenders approach their business. In earlier years, actually being repaid by borrowers was crucial to lenders. Now, because so much consumer debt is packaged into securities and sold to (other) investors, repayment of the loans takes on less importance to those lenders than the fees and charges generated when loans are made....'Today the focus for lenders is not so much consumer loans being repaid, but on the loan as a perpetual earning asset...'" This financial process pyramided until house prices, the collateral backing all those financial obligations, started to decline; then the loans of defaulting borrowers had to be written off.

*** add: Massive problems in structured finance prove an elemental principle in commerce, that continued trade has to benefit both parties. William Bernstein's excellent new book, A Splendid Exchange (2008), describes a trade practice originating in India that was evidenced in Mesopotamia (Iraq), "...the merchant placed a lump of wet clay over the closure of a container, then rolled or pressed the seal across the lump, impressing it with his mark. Left to dry and harden, the seal informed the purchaser that the merchant had guaranteed the contents of the container, and that it had not been tampered with in transit."


8/1/08 -

Will the recession look like a “V,” a “U,” or a “L”? We think its going to look like an elongated “U.”

The 5/08 S&P Case/Schiller index of house prices reported a further .9% drop, resulting in a 15.8% drop for the full year. The financial system will not stabilize until house prices do.

In their study of five major banking crises in the developed economies of Spain, Norway, Finland, Sweden, and Japan, Reinhart and Rogoff  (2008) report that real equity prices on average declined for three years, prior to the crisis, and the total drop was around 23%. In contrast to these, U.S. equity price began to decline shortly after this crisis began in August, 2007. Equity price declines have been moderated by expansive monetary and fiscal policies, of a nation that finances a large proportion of the world's trade and can import capital. There are, however limits, as the decline of the dollar illustrates.

B of A reported its second quarter earnings, without consolidating its Countrywide acquisition, B of A’s earnings grew by 213% over the previous quarter to $3.2 billion as the trading account swung from large losses to a small profit. Their loan loss reserving policies, however, specifically assume economic stabilization in the second half.

Due to an internal reclassification of assets, the bank booked an additional $980 million loss; flowing not through the income statement, but as a direct adjustment to the “accumulated comprehensive loss (income)” account under the equity section of the balance sheet. This is meant to be a temporary holding account for estimated gains and losses on "securities held for sale." We think that actual losses are somewhat higher than those reported on the income statement, calling into question the degree of the bank’s reported profit improvement in the near term.

In the second quarter, B of A's mortgage portfolio dropped $30.6 billion, or 11.5% from the previous quarter, as they reclassified some of their portfolio mortgages as "held for sale" without replacing these mortgages in the portfolio. A greater problem is the bank’s extension of credit to the rest of the economy. Total consumer lending dropped by $20.3 billion or -3.7%, and commercial lending increased. Their total loans outstanding continued to decrease, by -.39% in this quarter and -.28% in the previous. According to the IMF, a one percent increase of credit to the economy is extremely stringent.

The significant housing downturn and the resulting credit stringency are the very unfortunate fundamentals of this financial crisis. This recession is likely to occur in two stages: first there are problems in the financial system, and then problems develop in the general economy. We would rather be mainly concerned with investing in our favorite stocks, than with risk management due to financial systems problems.


This discussion from London's Financial Times is an excellent summary of what is going on in the financial system.


9/01/08 -

The S&P 500 closed at 1283. The market has been stuck in a trading range after closing at 1268 last month. Is this a likely bottom? We think not. Either finance and credit matters, or they do not. If they do not, then we could point to the very slight moderation in house price declines and the high reported 3.3% second quarter annualized rate of GDP growth, and say the worst has passed.

If they do matter, and we obviously think they do, then consider the following statistic from the Fed:                                                           

Total Bank Credit
(seasonally adjusted, billions of dollars)

Dec, 2007

Jan, 2008















Total bank credit extended to the economy increased to $9,451 billion dollars in March as banks will forced to honor their previous lines of credit and to bring off balance sheet assets, such as SIVs, onto their balance sheets. In July, total bank credit decreased to $9,395 billion. According to the Fed April senior loan officer survey, 55% of domestic banks-up from about 30% in January-reported tightening lending standards on commercial and industrial loans.

The IMF considers a 1% growth in bank credit extremely stringent for the U.S. economy. As the credit crunch enters its second year, we think that the fairly stable economic conditions at present are the eye of the hurricane. What has been a financial crisis will begin to cause problems in the real economy.

We draw, for the purpose of description, a comparison of the present economy with that of the 1930s. In 1929, mild problems began in the real economy, that ultimately translated into a complete collapse of the credit due to policy mistakes that allowed crucial financial institutions to fail. This time around, the situation is opposite. Problems started in the financial system due to profligate loan practices. Large Crucial financial institutions will not be allowed to fail, but problems in the financial system will this time spread to the real economy. .

Previous market cycles were simpler. The stock market went down because the Fed raised interest rates to control inflation. It went up because the Fed decreased interest rates, enabling early cyclical investment, such as real estate, to kick in. This financial crisis is a lot more broad in scope with international ramifications and a lot more complicated. The 8/27/08 WSJ reports:                     

"...(This increasingly complex financial infrastructure) helped drive the finance boom, but it is now acting as a vector of contagion. And the causal arrows don't point in straight lines from one troubled area to the next (as our descriptions above do). They twist back, creating vicious circles that gain speed and draw more markets and investors into the mess."

We think that a major precondition for the economic situation to improve, causing the "vicious circles" to stop spinning, is for the ability and willingness of the banks to expand credit. The 8/30/08 Economist quotes Shakespeare to describe this turbulent financial crisis, "When sorrows come, they come not single spies but in battalions." Our portfolio strategy remains risk control.


9/15/08 -

Yesterday Lehman Brothers Holdings, Inc., the nation's fourth largest investment bank with $600 billion+ in assets, filed for Chapter 11 bankruptcy. The financial markets are in turmoil; the S&P 500 closed at 1193, down 4.7 %.

At times like these, its useful to look back to history. Charles Kindleberger (2000 ed.) wrote what is probably the definitive study of financial crises. Between 1618 and 1998, 380 years, he listed 38 major financial crises ranging from the Dutch tulip bulb speculation in 1637 to the Asian financial crisis in 1997-1998. Although the objects of speculation differed, these crises had two main features:

                          1) Excessive leverage.

                          2) The contagion was usually world-wide.

How to gauge the impact of this crisis, as that will determine when to buy stocks? In spite of increasing values, we are not yet increasing our investment in equities. The scope of the crisis is very wide-spread, encompassing all sorts of U.S. financial assets and institutions. On 9/14 Bloomberg presented the following data:      

Losses and Capital Raised due to Subprime-Related Crisis

                            Losses            Capital Raised

World Total      $515 billion           $363 billion  

The IMF, maybe conservatively, estimates total losses around $1 trillion. About half the losses have so far been charged off. The likely course of events is a continued stream of chargeoffs *, not good for the markets. We do not like this conclusion, but this is probably where the facts are. This sequence of events will likely drive the S&P 500 lower. Will it be possible to pick a bottom? - we don't think anyone can. At this point, we are likely to add to stocks when their values become compelling and when the state of credit (belief) improves. **

* As a general issue, is market value accounting appropriate for leveraged financial institutions, particularly when markets panic? In the famous (infamous) chapter 12 of the General Theory (1935) Keynes noted, "Of the maxims of orthodox finance none, surely, is more anti-social than the fetish of liquidity....It forgets that there is no such thing as liquidity of investment for the community as a whole....Speculators may do no harm as bubbles on a steady stream of enterprise. But the position is serious when enterprise becomes the bubble on a whirl-pool of speculation. When the capital development of a country becomes a by-product of the activities of a casino, the job is likely to be ill-done."

At this time, investors seem to be scared of their own shadows because "the game,"  that Keynes also wrote about, has resulted in too much leverage.

** This is probably the most fundamental variable affecting the price of assets - particularly housing.


On 9/18 the government announced a plan to form a new corporation to buy up, not financial companies, but the dodgy assets on their books. This plan addresses the financial system's credibility problem, preventing its unraveling. But, who will be the happy owner of the losses?

If the assets are transferred at current book value, the current net worths of the institutions will be preserved but the government, that is us, gets roughly ($1 trillion in IMF estimated losses x 50% owned by U.S. financial companies - $258 billion taken so far by these companies = roughly $242 billion in additional losses). It is not politically possible for the government to assume these, nor should it.

If, as is proposed , the assets are transferred in some form of auction system, the net worth of the U.S. financial system will decrease by around $242 billion. That is not good at all, because those losses could translate into a major decrease in lending of $2.4 trillion, v.s. the 2007 U.S. GDP of around $14 trillion. These losses have to go somewhere; the most effective choice would have to be some form of loss-sharing between the government and the private sector. Furthermore, as William Issac former Chairman of the FDIC suggests in the 9/19 WSJ, bank assets should be marked to their economic (i.e. discounted cash flow) values. The economic assets held by banks should be valued on a long-term basis.

The plan increases the credibility of the U.S. financial system, but it does not result in the provision of more credit.* To get us out of this mess, this program will have to combined with one that encourages productive investment in the U.S. industrial base and in its infrastructure, as in the 1930s. Traditional macroeconomic tools, fiscal and monetary policy, are too general to be effective.


* What went wrong? In the 9/20/08 Washington Post, former Treasury undersecretary Peter Fisher who helped bail out Long-Term Capital Management, wrote, "The degradation of our credit process comes about when lenders stop paying attention to borrowers' ability to repay out of cash flow and make decisions solely on the basis of the expected value of the collateral...". Then, layer on top of that inapplicable Gaussian pricing models that management didn't understand. The result was not rocket science and a loss of hundreds of billions of dollars.

The handling of these resulting losses goes to the core of the capitalist system. Under this system, people are responsible for their own actions so if they make the right decisions, they prosper. If they mess up, they have fewer resources with which to mess up. Under socialism, the government allocated society's investments. People were thus not responsible and neither did they have freedom. The problem of this financial crisis is that those capitalists who were responsible, proved not to be. The philosophical, ideological, practical question is whether the private sector is capable of channeling investment where it ought to go. Keynes ends chapter 12 with the observation, "I expect to see the State, which is in a position to calculate the marginal efficiency of capital-goods on long views and on the basis of the general social advantage, taking an ever greater responsibility for directly organizing investment..." The subsequent British experience with heavy government economic involvement was no success either (recall Margaret Thatcher), so any government involvement would have to be very well designed.


At what price should the government bailout value these toxic investments? The 9/23/08 New York Times writes, "The trouble is that these investments (e.g. CDO2s) are so intertwined and complex that no one seems able to figure out what they are worth. So no one has been willing to buy them...Now the Treasury aims to clear the fog by buying up these investments. But their value is as mysterious as ever...'The problem is people are operating in a world in which nobody knows that the hell is going on.'" The people who best know what is going on are the accountants. The purpose of this bailout is to get funds flowing again to borrowers. The government could buy these investments at current book value -and as has been suggested- taking stock in the institutions availing themselves of this program. add: There would be an improvement in the banks' liquidities, no depletion in their total net worths, and thus an increase in their abilities to lend.

Whats going to encourage the banks to sell their investments? Maybe some kind of accounting rule that excludes from their balance sheets and net worths assets whose values cannot be easily determined, that would automatically knock out the CDO2s, maybe even some of the CDOs. This would ensure that the worst assets are purged from the banking system and that the government gets valuable stock in return...provided the same mistakes (not to place blame) are not repeated.

These measures, the Treasury suggests, are appropriate for failed institutions; in this intermediate case the market should be allowed to work. The problem is the collapse of the Gaussian valuation convention regarding many mortgage securities. Many complex securities created by the financial system cannot be credibly valued, therefore there are and can be no market solutions concerning them.


9/29/08 - 10/1/08

The S&P 500 decreased to 1106 and then recovered to 1161. The House failed to pass a $700 billion financial system bailout. In an election year, Congress merely reflected a general sentiment that overeacted about real estate on the way up and was wrong about the need for a bailout on the way down. Time magazine reports that calls to Congress were 100:1 against the vote. After an intense stock market reaction, the bailout plan is now up for reconsideration with some modifications; the resulting plan will probably prevent a panic, but an effective plan would still have to recapitalize the banks and enable the renegotiation of mortgages.

We hope our readers are substantially in cash or appropriately hedged. Our inclination is to wait before purchasing more stocks because the financial system is very badly stressed by the subprime mortgages that are spreading contagion abroad, and by an expected economic downturn in the U.S. The extent of globalization makes this financial crisis unique, dropping as many shoes as a centipede has feet.

What is the nature of the subprime securities that have to be bailed out? The following analysis discusses the unrealistic "stylized facts" of mathematical financial economics that determined their credit ratings. The early Enlightenment assumed in theory the calculability of everything, from the atoms of the universe to the behavior of whole societies. Quantitative finance makes the same assumption regarding the exact calculability of investment risk and return. add: By the late Enlightenment, people realized that knowledge is provisional and expanding. Although the markets are presently in a state of extreme uncertainty, more knowledge -to the extent possible- is better than, as Keynes (1935) described, "the forces of time and our ignorance of the future..."


10/6/08 -

At the close of the market on 10/5/08, the S&P 500 dropped to 1057, a decrease of  3.9 % for the day. There are at least three possible ways to write this market comment:

1) To commiserate - not useful.

2) To panic - Value investors don't panic when the markets drop. They panic when the markets become very overvalued. We began to sell after considering the train of mortgage events last year and the fair valuation of our stocks.

3) To discuss when to buy more stocks - This discussion might not now seem apt, but it is the most useful. This is how value investors think. Although five out of the nine stocks we are considering for purchase have reached their targets, we aren't buying yet. The following discussions will be qualitative, because they relate to the factors of judgment - when to act or not to act at a time when Mr. Market is calling the entire financial system into question. The general comment, "Not since the '30s" is correct.

The 10/13/08 issue of U.S. News and World Report describes FDR during the 1930s, "FDR also found that flexibility was key. 'Roosevelt was experimental....'" We're value investors; but will also consider likely events and the behavior of Mr. Market.


The current financial crisis is not a liquidity crisis that can be solved by flooding the financial system with money that is not lent out. It is a banking solvency crisis, requiring government intervention. Put simply, the banks made too many bad loans and the government has to replace the capital lost. As a short-term measure (we hope) the Federal Reserve Bank has announced a plan to bypass the private banking system and directly refund, if necessary, maturing corporate commercial paper. The Fed chairman, Ben Bernanke, has thoroughly studied the Great Depression of the '30s and evidently thinks that this is a necessary measure. This action, to use economic jargon, changes the structure of the economy and is an example of the above.


10/8/08 -

The S&P 500 closed at 985 after closing at 996 the previous day. All nine of the nine stocks we had previously designated hit their purchase targets. Under the present circumstances, that fact alone would not have caused us to add to equities when there are substantial system questions, international in scope. A recently issued IMF Global Stability Report suggests in stark terms the possibilities:

The (report)...notes that the strains afflicting the global financial system are expected to deepen the downturn in global growth and restrain the recovery. Moreover, the risk of a more severe adverse feedback loop between the financial system and the broader economy represents a critical threat. The combination of mounting losses, falling asset prices, and a deepening economic downturn, has caused serious doubts about the viability of a widening swath of the financial system.

Value investors implicitly assume that the system will hold together. The British government announced an eventful major bailout of their financial system, under these terms:

1) Boost bank capital by buying preferred shares of up to $87.9 billion.

2) Provide a bank bond guarantee for around $434 billion.

3) Provide $347 billion in additional liquidity to the British banking system.

(1) addresses the issue of bank net worth (solvency) and could represent, as feared, the nationalization of the British banking system. Royal Bank of Scotland shares dropped by 39% in a panic. The statement issued by the British government, however, noted that if the government were to provide capital there would be "detailed" discussions with the banks that would "need to take into account dividend policies and executive compensation practices and will require a full commitment to support lending to small businesses and home buyers." The government, in addition, "is also willing to assist in the raising of ordinary equity if requested to do so."

The British government effort therefore assists the banking system, rather than taking it over. The United States may come up with different solutions, but this effort - also possible in the U.S. and generally - suggests that the light at the end of the tunnel is not necessarily a barreling locomotive (equity investors tend to be optimistic). We are increasing our stock investments very slowly, according to the economic situation, knowing that stocks are by nature long-term investments and that the market can drop further.



The 10/9/08 NYT reports that the Treasury plan under discussion for recapitalizing the U.S. banks resembles the British plan. Government now has to undertake many measures to get the economy to behave normally, MC=MR as in the textbooks. The recapitalization of the banks, although necessary, will probably not result in much increased lending because the banks have also tightened their credit policies. Government now also has to assist the appropriate restructuring of purchased mortgages, which will reduce foreclosures and prevent housing markets from overshooting, and maybe guarantee all bank liabilities. 

In the context of necessary bank recapitalizations and lending, the reverse auctions contemplated under the bailout passed by Congress are extraneous detail. The free markets are not now allocating capital rationally because a rush for liquidity is on, as Kindleberger (2000 ed.) wrote, a torschlusspanik - a closing door panic. We think there is an advantage to remaining (somewhat) rational. add: Governments are trying to error-correct the entire world financial system.


10/15/08 -

On October 14th, the Treasury announced a program that will guarantee commercial paper, -and along the lines of the British program - invest $250 billion in the preferred stock of banks, guarantee new bank debt and all interbank transactions. The stock market, having dropped to an October 10th low of 840, increased to 1003 and then dropped to 908 at present. The market, its mind concentrated again, shifted its attention from a complete financial system meltdown to the ongoing recession.

Since the Treasury actions were coordinated with those of the other G-7 nations, we are less concerned with the major risk that the financial system will unravel. We cut our hedges, bought stocks that we think have secure dividends, and established initial positions in growth stocks that had become bargains; in fact all the stocks we had earlier targeted. The major emphasis of our portfolio is dividends, and will invest in more growth stocks when we think the economy will begin to grow again.


Keynes (1935) pointed out several mitigating factors concerning "ignorance of the future." Among them being, "there are many individual investments of which the prospective yield is legitimately dominated by the returns of the comparatively near future (like high dividend yields)." Expecting the receipt of dividends is a clear example of buying a stock for use, rather than for short-term speculation.


10/24/08 - 11/1/08

What’s a rational level for the S&P 500, assuming a deep recession? In December of last year we “stress tested,” so to speak, our econometric model of the S&P 500 assuming an expected industrial capacity utilization level of 67% (76 % currently). Our model predicted a level of 1150.

The stock market, in fact, has traded at a level of 853. Our model remains valid because the statistical process allows for very large error-correcting variances from predicted values, rather than a more placid mean-reversion. But a financial model, or any engineering model, simply cannot accurately predict the specific effects of panic or turbulence. Investors panic about every ten years, not every thousand or ten thousand as the Gaussian model suggests. This truly simple observation requires absolutely no rocket science. It requires going to Kindleberger (2000 ed., p. 223) and dividing the number of years by the number of panics. Financial panics are like turbulent flow in the natural world, for instance when a wave breaks. We requote Richard Bookstaber (2007), describing the panic of 1987:

"The huge volatility of the market broke down all but the most fundamental relationships between the market securities. The usual day-to-day world where investors cared about subtleties like corporate earnings or analyst forecasts dissolved as the energy of the market was turned up. All stocks moved together; if it was a stock, it was sold. The market hardly differentiated between domestic and foreign, small cap or large. It was like plasma physics. As matter becomes hotter it becomes less differentiated…just a seething white-hot blur of matter."

As uncomfortable as current market gyrations are, we are probably making (with fingers crossed) some of our best investments for the future. This is the time when a value investor will find all sorts of gems thrown out with the rubble, by leveraged and momentum investors whose minds are now concentrated on everything but the investment fundamentals. With recent central bank debt guarantees, our major concern is not the meltdown of the financial system; but the state of the real economy. The U.S. and the world are in for difficult times; it will be many months before the U.S. economy begins to recover - but at least a light at the end of the tunnel is possible.


Shareholders have a right to have their (always) reasonable questions answered. We asked such a question of a well-known European company, and received the reply that our question was too "hypothetical." We are no longer a shareholder in that company* and are considering approximately equivalent replacements. We also note that the S&P 500 increased by more than 10% on 10/28/08. This offers incontrovertible proof that there is a price to be paid for being out of the market when it is going up.


* The minimum honest answer would have been, "We're considering the question (translation: our minds are concentrated on that issue) and cannot comment at this time."


11/12/08 -

The S&P 500 closed around 852 again. We would rate the now avoided cost of a financial system meltdown much higher than some quarters of negative GDP growth. The market sees this differently; prices continue to be affected by the necessity of deleveraging rather than the choice of investment. In any case, we think that this is now a time for investors to be patient both with their existing portfolio and when considering new purchases.

This leads to an interesting point. On 4/23/07 the S&P 500 closed at 1481. We were cautious. The stock market partied on, driven by buyouts and stock buybacks that postponed the dire day. Now, in spite of somewhat improving fundamentals, the market is near a recent low due to deleveraging. Because market prices are also affected by short-term structural factors (who owns what), an investor who invests according to the fundamentals has to be willing to wait for reality to assert itself, which it does.

add: Since the markets are obviously capable of irrationality, how does a rational investor react? The Sept, 2003 National Geographic gave some good advice on how to handle emotions, say you encounter a real bear in Tahoe. "Gut instinct has helped us survive over the course of human evolution. But gut instinct can backfire. It may not warn us of dangers from unfamiliar sources....(also) Feelings alone can also cause us to make illogical calculations...But a saavy risk analyzer uses both the emotional and analytical systems to make good decisions...You need your feelings to put a cross-check on your analysis, and you need analysis to keep your feelings in check."


11/20/08 - 12/1/08

The S&P 500 closed at 752. We began our website to explore the nature of the financial markets. We did not anticipate that the way to learn about markets was to study the effects of their near absence.

The liquidation of all financial assets other than treasuries continues, as Bookstaber (2007) above describes. We are frankly surprised at the continued extent of these sales; but the market having previously thought that taking on risk would lead to its own reward, by unsound lending, has now gone to fear, believing no one in Washington can do anything right to save the financial system from itself.

The two sources of stock returns are dividends (usually neglected) and capital appreciation (always sought). If your stock portfolio is configured for dividend income, stock dividend yields are at a record high and dividends are less volatile than stock prices. To take the most extreme case, by 1933 S&P composite dividends had dropped by 55%; but stock prices had previously dropped by 85% *.

According to the 11/21/08 Value Line (and our analysis of individual stocks reaches a similar conclusion), the modeled median price appreciation of 1700 stocks is a record 160% over the intermediate term, exceeding greatly the level in 2002. Dispassionate financial analysis would say buy! Emotion would say sell! When equally weighted considerations contradict, we simply don't act.


* Is it time to buy canned goods and bottled water? Robert Solow, an economist from MIT, points out that in the '30s the unemployment rate was 25-30%. Now, its around 6.5%. We also know what to do, and that piece by piece the solution to present problems is being put in place. Those who lived through the Depression know how bad things can really get.


Value investing is a philosophy, providing a guide for conduct in one's investments. It does not address the behavior of Mr. Market, other than to note that the stock market provides either opportunities to sell or to buy when other investors are irrational.

In this website we have addressed the behavior of the U.S. stock market, thus opening the possibility of market timing, identifying both the peaks and troughs of market behavior. But, as our 11/12/08 discussion indicates, market peaks and troughs are caused by structural behaviors (who owns what). They are difficult to analytically predict - especially the troughs. There are two reasons for this:                

1) The decline of the stock market from a peak, when reality finally catches up with market misconceptions, is more precipitous and obvious than its rise from a trough. It is, however, illogical (and in bad form) to dump stock into collapsing markets. Value investors panic near the top; leveraged hedge funds panic near the bottom.

2) There is a very large structural economic change, due to the necesssary role of government to bail out the financial institutions. The Fed has increased the size of the central bank's balance sheet by asset purchases and is shifting the composition of that balance sheet to non-treasury investments, like commercial paper. See Bernanke (et al, 2004) for the general idea of "quantification." In economic theory these measures would not have a real effect. For instance, if the Fed were to increase the money supply drastically by large-scale asset purchases that would only increase inflationary expectations. However, when the markets are seized up and long-term expectations are calculated in days, these measures are a necessary and a direct substitute for private lending. Even the socialist economy of the former USSR allocated capital, so to speak.

We think that government intervention in extremis will prevent a catastrophic meltdown. However, the quantitative effects of hundreds of billions of dollars that the government is lending to the economy - and bypassing the seized up financial markets - is presently unknown. Add to that the effects of possibly another trillion dollars of government spending over the next two years. (Again, we call no market troughs. We hope our readers are investors rather than traders*.) The massive task now facing government is to get the financial markets functioning again, and efficiently so. Our next article will discuss, What Happened?

* Philip A. Fisher was a quintessential buy-and-hold growth stock investor. Yet, even he stated an exception. In Common Stocks and Uncommon Profits (1996 ed, p. 74) he wrote, "Unless it is one of those rare years when speculative buying is running riot in the stock (we add, credit) market and major economic storm signals are virtually screaming their warnings (as happened in 1928 and 1929), I believe that (investors with large locked in profits) should ignore any guesses in the coming trend of general business or the stock market." Value and growth stock investors are focused primarily on companies, but macro events sometimes matter. Like now. 


12/08/08 -

The S&P 500 opened at 883. We've continued to add stocks to our portfolio. In light of the quantitative uncertainties above, why have we made more stock purchases? The U.S. government and those around the world announced substantial increased expenditures to make up for private expenditure shortfalls. In spite of abysmal current economic statistics, the qualitative element of increased government spending is going to be in place, and the U.S. expenditures will likely be well managed. The possibility of a light at the end of the tunnel has grown. It would be very good idea for Congress to bail out and restructure the Detroit automakers; it also makes good business sense. The main issues aren't fairness; they are the current state of the economy and preserving the U.S.'s industrial base, and most important, its possibilities for the future.

We purchase stocks according to their values. Market timing is for the hedge funds.


12/10/08 -

Congress will likely approve a bailout of the Detroit automakers, thus also averting a crash of the industrial system. The various and sundry measures that government has taken to avoid system crashes will do just that; but economic growth will cease over the near term as the economy - in intensive care - recovers from this credit binge. Our stock investments (this does not contradict the above at all) emphasize the tangibility of current dividend yields, now a major component of total expected stock return.


The Senate did not approve a bailout of the auto industry. Opposition insistence that the auto companies should be reorganized in Chapter 11 blindly (that is ideologically)* ignores the facts that no one will buy a car from a bankrupt auto company and that putting the auto parts supplier receivables, and thus their respective net worths, into further question (a commercial detail) will likely bring down the industrial system. The Bush administration can, however, supply the bridge funds from TARP.

We will discuss the risks to the financial system and to the real economy in a January, 2009 posting. This economic downturn is not like recent cyclical downturns because credit problems have seized up most of the world's financial system, with the stock market providing a running commentary on this macro state of affairs. This situation is, however, not exactly like the 1930s because governments are set to do something about it: but the financial systems are complex, the issues are complex, and as a result the effects of their remedies will be directional, rather than biblical. We are in the process of trimming back slightly on our stock investments (read our 12/08 posting above), to reduce short-term risk, and note again that we are investing primarily for use rather than for sale.


* This is a brain-teaser. If you were a Japanese automaker manufacturing in the United States, why would you not want the Detroit automakers to collapse? There are two reasons, the first is operational and the second is competitive.