Letter – 2008 Q4

The best thing I can say about 2008 is that it is over. The second best thing I can say is that we were fairly defensive, and even though our results are disappointing in absolute terms, they are better than most broad-based equity mutual funds and substantially better than some of the best known funds . Third, we were less volatile than most comparable accounts. We never fell as far in October and November, but we underperformed on the days with big rallies.
The S&P 500 had a total return of negative 37.0% for the year, which included a price drop of 38.5%. Your account was returned XX. The year would have been somewhat better but for a poor third quarter when I hung on to energy and materials stocks for too long. In the fourth quarter, the S&P 500 lost 21.9% and your account returned XX.

I have written a 30 page treatise on the forces that produced these market results. This will eventually be part of a book on the history of the stock market since the liftoff in 1982. I’d be happy to email the early draft chapter discussing 2007-08 to you if you are interested in that much depth; just let me know. It chronicles the interplay of too much leverage with some serious regulatory failures. Here is a nutshell version from veteran Barron’s columnist (and Yale Law school valedictorian) Ben Stein:
“If someone had told me Treasury and the Fed would allow the fourth- or fifth-biggest investment bank in America to fail, I would’ve scoffed. But they did it, and we got a stock market crash, a severe recession, and national fear as the result. The night Paulson and Bernanke let Lehman fail was the night they drove old American investors down…. It goes to show what stupendously bad Treasury stewardship can do.”

There were clearly things that I did not see in advance, but we did carry the highest cash balances that I’ve had since 2002. I’m surprised that oil prices have fallen so far below the marginal cost of production. Thus even Exxon fell 13.1% in 2008. I was surprised that in the wake of Sarbanes-Oxley that statements made by executives of firms such as AIG were completely unreliable. Needless to say, I was shocked at the way Paulson dealt with Lehman; despite his recent attempts to change his explanation of the situation, it did not have to be.

There is a wider range of opinion on the prospects for 2009 than is common at the beginning of a New Year. This market environment has created both substantial risk and opportunity. Stocks are clearly cheap. The PE ratio for the overall market is low, and this is all the more compelling because current interest rates normally imply higher PE ratios. Finally, some value investors look at price in relation to peak earnings for cyclical stocks. That approach led to ten-fold gains in stocks such as US Steel for people who bought in 2003, and one day will do so again.

But the market was quite reasonably valued at this time last year. The problem is with the “E” part of the equation. Projected earnings are not particularly reliable in this environment. A year ago, analysts thought that GE would earn $2.44 in 2008; now that estimate is $1.90. For JC Penney, the estimate has slid from $4.85 to $2.60 in the same time frame. For Prudential Insurance, the slide was from $8.19 to $3.45. You get the idea.

Estimates for overall earnings for the S&P 500 in 2009 range from $50 / 53 (Merrill, Goldman) to $70 / 71 (Oppenheimer / Deutschebank). A PE ratio of 9 on the low end of those estimates suggests an S&P 500 Index level as low as 450, and a PE of 15 on the high end of those estimates suggests an S&P level of 1065. (It ended the year at 903.25). For reference, S&P 500 earnings for 2007 were $82.54 and 2008 will probably come in at about $65.40, giving the market a PE of 13.8 based on trailing earnings.

Obviously, part of the problem is that people don’t buy when sentiment is bad. I remember writing in my quarterly letter in April 2007 that I get worried when analysts talk about the market going higher because of seemingly unlimited liquidity. Now we have the opposite problem. There is indeed a record amount of cash on the sidelines, and it could ignite a major rally. The cash in money market funds amounts to about half the value of the S&P 500 stocks – a higher level than in 1982. But who knows when people will decide that it is time to deploy that cash. I am hopeful that the dawn of a new administration and a commitment by the federal government to stimulate the economy will produce a turn in sentiment.

Some additional stimulus has come from the drop in oil prices. By one estimate, the drop in gasoline prices alone has translated into a $240 billion tax break for consumers. On the other hand, the Fed reports a drop of some $7 trillion in household net worth since it peaked at $63.6 trillion in the 3rd quarter of 2007.

The biggest negative that I see is that the leverage has not yet been completely wrung out of the system. Banks are still too leveraged, and that makes it difficult for them to make new loans. Bank lending is the lifeblood of the economy. By one aggressive estimate, Citigroup is still leveraged at about 45:1. An acceptable figure would be more in the neighborhood of 12:1.
The Financial Accounting Standards Board (FASB) apparently recognizes that it has contributed to the current mess by requiring banks to write down perfectly good assets to unreasonable levels, thereby contributing to the current instability. Officials there have hinted at modifications to accounting rules that will help to stabilize the balance sheets of financial institutions. This would reverse the negative impact that FASB regulations had particularly on financial stocks in 2008.

General conditions in the credit markets are improving, which should be constructive. General Electric fell briefly below $13 in November from $37 at the beginning of the year primarily on fears that it would not be able to borrow as needed in the commercial paper market. Those fears have eased somewhat.

Bear markets have a way of sucking people in. Every time there is a rally, there is a reason to believe that “this is it”. But you never know when another grenade lurks – it could be the automakers, it could be instability in insurance, it could be weakness in the dollar; if there is to be another down leg, it is most likely something I haven’t thought of.

I’m inclined to be conservative until the market shows more signs of stability. For instance, I would regard a move above the 200 day moving average as a probable indication of a change in trend. Of course, the market can do that, and still go right back down (as it did recently after a close above its 50 day moving average). There is no predictive value in moving averages. Rather, there is simply a discipline in waiting for signs of an uptrend before being fully invested. Meanwhile, we’ll seek situations where compelling value should limit downside risk while providing large upside potential.

I heard one consultant make a presentation about the importance of long term investing, citing the large rallies from bear market lows. Of course, that presentation assumed that you bought exactly on the day of the low in question. When I asked how those returns would change if you got in 90 days before each low, he had no idea. Therein lies the dilemma. The stock market has always gone higher in the long term but there can be pain if you buy too early in a bear market. Yet people have been predicting the end of the world for 2000 years, and the end of America for close to 200 years. At some point, we will be very happy to own stocks at today’s prices. I’m quite sure that will be true five years from now. Warren Buffet agrees. Good results may come even sooner if government stimulus is properly applied; e.g. the housing market may stabilize sooner than expected. Other measures could improve confidence quickly. For example, the SEC under new leadership might reinstate the traditional restraints on short selling. That is the kind of thing that could help to restore confidence.

Those are reasonable possibilities, but the short term is hard to predict. Nevertheless, it is highly unlikely that cash and Treasuries will keep us ahead of inflation. A diversified portfolio is much more likely to do so, and it offers the chance of more substantial accumulation of wealth. That may mean some gold and foreign exposure in addition to US stocks. We will continue to seek the best opportunities, invest accordingly, and control risk appropriately. We will also do our best to communicate with you during the year ahead about market developments and asset allocation. We urge you to contact us anytime you have questions or concerns about your current asset allocation. We are always happy to discuss those issues with you. You are now about xx% invested in stocks. We’re also happy to provide shorter term updates by email if we have an email address for you. Please don’t hesitate to contact Art or me anytime you have any questions, concerns, or related needs.

Here’s looking ahead to better days for the market and the economy.


* Past performance is not necessarily indicative of future performance. Results for individual clients may vary. Results are not audited. Byrne Asset numbers reflect the addition of certain dividends and deduction of all fees. S&P numbers are based on the total return of Vanguard’s S&P 500 Index Fund.

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