Good Riddance

Posted on January 7, 2009 by David Laidlaw 

During the past year, almost everything that could go wrong went wrong in the economy and the markets. The two most astounding developments were the revelation of how fragile our banking system was and the degree that the government became involved in the private sector.

 Many commentators and investors understood that residential and commercial real estate traded for purely speculative valuations from 2000 to 2007. However, the catastrophic effects of the popping of the real estate bubble were spectacular. Many of the country’s largest banks and investment banks were left holding almost worthless packaged debt that they themselves created. The interplay between these mortgage-based products and financial derivatives such as Credit Default Swaps caused a domino effect bringing down other financial firms such as AIG.

Wall Street no longer exists and the world’s largest banks are basically wards of the state.Lehman Brothers failed, Bear Stearns and Merrill Lynch were purchased by JP Morgan and Bank of America respectively, and Goldman Sachs and Morgan Stanley converted to commercial banks.

The second development was the panicked governmental response whereby the Treasury, Federal Reserve and Congress took any measures possible to try to forestall the inevitable contraction that is now occurring. The end result is that the government nationalized a number of industries. The Federal Government now controls the largest bank (it has invested $45 billion in Citi and guarantees $300+ billion of its assets), the largest insurance company (AIG), the largest mortgage companies (Fannie Mae and Freddie Mac), and two out of the three domestic automobile manufacturers (GM and Chrysler). When and if the financial sector and other industries return to private hands are unanswerable questions.




The National Bureau of Economic Research determined that the recession started in December of 2007. The impacts of the credit crunch deepened the recession dramatically as bank lending and finance activity from the private sector halted. Economists predict that gross domestic product decreased by as much as 5% during the 4th Quarter of 2008, which is the sharpest contraction since World War II. During the coming year, unemployment will most likely increase dramatically from 6.7% to anywhere from 8-10%.

The government’s monetary policy of dropping rates to 0% will not work until the fear in the credit markets subsides. A commentator on Bloomberg radio referred to this activity as “spreading gasoline on ashes” suggesting that there is no economic fire that lower interest rates will spark.

The next major stimulus is the massive plan that will await President-elect Barack Obama’s signature upon his inauguration. Most reports suggest a Trillion dollar stimulus plan involving lots of infrastructure spending. Certain spending is sorely needed and will help our economy function more smoothly; however, any spending will most likely include a healthy percentage of waste that does not increase productivity.

Over the next three to ten years, we believe most financial assets, except U. S. Treasury Securities, will perform well since their prices are so devalued. High-quality corporate and municipal bonds maturing in 10 years provide yields of roughly 7% and 4% per annum. After-tax returns for municipal bonds are significantly higher since the interest earned is exempt from Federal Income Tax.

Common stocks are also historically cheap. The S&P 500 sells for about 13 times earnings (and lower when financials are excluded) what it earned during the previous 12 month period and provides a dividend yield of about 3% which is more than the yield on the 10-year Treasury bond.

Financial stocks will be handicapped going forward since the government will most likely influence their lending decisions and thus their profit potential.Banks are already being pulled in two different directions.Regulators are questioning the solvency of borrowers on one hand while elected officials are decrying the lack of lending given the government’s bailout largesse on the other.

In other sectors, we have been opportunistic purchasers of companies which we never expected to be able to buy at these price points. Google now trades in line with Procter & Gamble on a price to earnings basis. P&G is a great company, but Internet advertising will grow much faster than sales of laundry detergent and razor blades over the coming decade. We also established a position in CME Group – formerly the Chicago Mercantile Exchange.Similar to Google, CME traded for over $700 per share earlier in the year and we added it to portfolios for less than $200 per share. We believe more business will flow to established exchanges and that CME’s franchises in interest rates, equity futures, commodities and currencies are very strong.

Recently, the stock market has produced very severe losses; however, there are still ample opportunities for future growth for those able to absorb the near-term volatility.