Portfolio manager’s Letter December 2001
It has been over eleven months now since the Federal Reserve Board started lowering interest rates, with the economy still not showing any life. The bears have decided that we have slipped over the edge and become Japan. “Monetary stimulation is not going to work this time”. Of course, it is possible they are right. Japan lowered their interest rates to zero (and below) and their economy is still in the toilet. I, as investment manager, hate to be negative but I have a problem with this theory. For the last fifty years every time the FED has eased substantially the result has been a recovery in the economy and the Stock Market. “But this time it’s different” Say the Bears, gee why does that sounds familiar? Are they right? is it time to fight the FED? For fifty years the one rule that has always worked is “Don’t Fight The FED“. Now there is talk that “Monetary policy does not work anymore”. Maybe, but forgive me if I, as investment manager, remain skeptical.
Compounding my skepticism is the fact that for the first time in recorded history, the government has managed to coordinate fiscal and monetary policy. They actually expanded monetary and fiscal policy at the same time. When I went to school this was considered to be politically impossible because by the time the congress decided to act the FED would already stimulated the economy out of its whole.
Now just in case there was any question as to the future direction of our economy, we have added in to the economic future, the mother of all economy stimulators, a new war. Ah, but “this time it is different”. I’m sorry I forgot. “Monetary policy does not work anymore, Fiscal stimulation is too little too late, this war will not stimulate.” I, as investment manager, have read all of the above, of coarse it is possible that there will be no recovery. If something has always happened in the past that does mean that it has to happen this time, but forgive me if I choose not to play these odds. Basing your investment decisions on the assumption that the economy will continue to decline seems to me like betting on the hundred-year storm. Maybe we are headed to permanent recession, but the odds are against it.
Sure, they had one in Japan but that does make it more likely that it will happen here. If you bet on the prefect storm, you win big if you are right, but most of the time you are going to be wrong.
Perceived Risk Vs Actual risk
Life is ambiguous. In the market perceived risk and actual risk are two entirely different things. Actual risk is lowest when the perceived risk is highest. Perceived risk comes from pain. The more you watch the value of your stocks go down the more clearly you understand the risks that are presented by investing in stocks.Actual risk on the other hand is a function of valuation. In a Bear market perceived risks grows as the markets go down because the damage keeps getting worse, but Actual risk is declining because value is increasing as stock prices decline. At a market bottom the perceived risk is very high whereas the actual risk is Zero. When I see a money manager bragging about being 85% in cash at a point where the market has been declining for two years I feel he is dealing with the perception of risk. If he were dealing with actual risk, he would be bragging about being 85% in cash in March 2000. Today the perception of risk is high. I do not know how much risk there is left in this market, but I do know that it is much lower now than it was two years ago. Much of the perception of over valuation today has to do with PE ratios, but right now PE ratios might not be the best way to value a business.
PE ratios are always high during a recession. Not only is there a natural drag on earnings from the slowing economy but accounting games ramp up as everyone tries to write off everything they can imagine. Earnings are down and the stock has already taken bath so the artists in the accounting department decide to dump all their problems into the down quarter. The really creative ones are hard at work right now trying to think up reserves they can write off during the recession then can add back in to earnings later. This helps to solve some of those messy problems that come from lumpy earnings in the future. Today the average PE is distorted by impact a few large companies with high valuations that dominate the S&P.
The last Time the average PE was 10; long-term interest rates were 18%. Today Long term interest rates are 4.5%, and pushing levels that we have not seen since the 1950’s.
Pain is the Mother of Wisdom
Now that we are in a recession everyone seems to focus on the pain. This is this very human tendency that has lead to the rather naive belief that recessions are bad, and that the country would be better off if we could just get the government to fix this problem. Indeed thanks to “Snake oil Al” with his soft landing elixir many people believed that we had solved the problem, and it was bye bye for the “R” word. But alas, no such luck, the monster has returned from the grave. Rather than wallow in depression I think it is more interesting to consider the possibility that our attempts to avoid a recession do not prevent pain, but in fact make the pain worse. Contrary to the impression created by our friends in Japan recessions generally do not last forever. Recessions that we have experienced had since the end of the Second World War have been short and therapeutic. Yes there is the pain from lower corporate profits and higher unemployment but in economics, pain is good. You find out who is swimming naked. Problems like Enron’s self-dealing or Lucent’s selling of products to people that could not pay; tend to bubble up to the surface. Employment cutbacks cause pain to the individuals affected, but eventually they increase productivity. Each recession will eventually produce a recovery precisely because of what we learn from the pain it brings to us, and economy will eventually emerge stronger and with fewer long-term problems.
A crisis on the scale of the Enron collapse, while certainly tragic for the employees and investors, who lost money, Can have important long term positive impacts. New rules will be written’ and old patterns of behavior will be modified. The Environment of accounting games that nurtured this disaster has been tolerated for many years. It is now obvious to even the simple mind, that this tolerance is profoundly deleterious to the financial health of investors. Sloppy and creative accounting has been allowed by auditors and encouraged by stock analysis whose job it should have been to serve the interests of investors. It seems pain is necessary in order for us to get the reforms. So maybe it will be that Enron has given us enough pain that some of the changes in accounting rules, that should have been made years ago, will finally come to pass. When it comes to legislation we only learn the hard way. The SEC and most of our securities law was enacted because of the 1929 crash. Meaningful reform just does not happen in a bull market, because everyone is fat and happy. While there is still much shareholder abuse still in this country, there is less here than in other markets. To the extent that we have shareholder rights in this country it is the result of rules written in the wake of disasters. It does not seem likely to me that we have entered a recession that is different from the ones that have gone before, and absent that, the most likely coarse of the market for the next year or so is up. This certainly does not mean that all of our long-term valuation problems have been solved but like the war on terrorism this will be a struggle with many battles.
Some of the most important changes in behavior I expect as the result of our current economic decline will be at the Federal Reserve board. Looking back on the nineties it appears now, that monetary discipline was much too lax. The 1994 soft landing, together with Greenspan’s quick intervention to lower rates in the fall of 1998, and his over reaction to the year 2000 pseudo crisis, where, to some extent, the cause of our great tech bubble. The FED can (since it is a human institution) learn from its mistakes. If this is indeed the case do not expect that recessions of the future will be separated by ten years.