Roller Coasters - Bears - The Last Supper and a Big Thanks!

Roller Coasters - Bears - The Last Supper and a Big Thanks!  (Printer Friendly Version)

Kendall Anderson, CFA April 5, 2008

A few years ago I had the pleasure of visiting Las Vegas. Personally I am not a big fan of games of chance, but I have been married for a long time, and as all of you know, a successful marriage requires some compromise. So, I ended up in one of the casinos on the strip with my lovely wife, her parents, two of her sisters and their husbands. For those of you who have been in the Vegas casinos you know that the gaming machines are normally lined up row after row full of lights and sounds. It seems my family became enamored with a row of slots that were based on an Elvis theme. I have a vivid memory of all seven of my family members sitting side by side and being mesmerized by these machines, feeding them quarters with the hopes of having Elvis sing them a song while filling their cups full of quarters.

Being one not to get in their way, I gave Kathy a couple more $20's and took a walk down the strip.   My destination was the Stratosphere Hotel & Casino. Back in the early 90's I was invited to participate in ownership of the Stratosphere. Not only was I invited to participate personally, the organizer wanted me to recommend the same to my clients. I promptly declined as I had already learned my lesson well from previous ventures that sounded to good to be true (The Stratosphere Corporation declared bankruptcy with all original owners loosing 100% of their investment). But that is not the reason for the visit. I truly wanted to take a ride on the "Big Shot". This is the roller coaster that made the Stratosphere famous. As I remember I took the elevator to the top, bought a ticket and then climbed a staircase to reach the coaster. This is over 1000 feet above the strip below. I was strapped into a chair, feet dangling and then launched 160 feet into the air at 4 G's. Upon reaching the very top you enter a free fall at negative G's. I'm not going to be macho here; my stomach did churn a bit. But as I have learned, the best way to get over a fear is to just do it again... which I did.

For all of us invested in common stocks, the month of March was almost as good of a ride as the "Big Shot". On the last day of February, the Dow Jones Industrial average dropped 315 points. From March 6^th through the 9^th the same averages dropped another 300 points. On March 11^th the Dow was up over 400 points. This would seem to be enough for one month, yet it didn't stop. On March 14^th the Dow dropped about 200 points followed by another 400-point positive movement on the 18^th. From the 25^th through the 28^th the index dropped another 300 points, which brought us to April 1^st when it climbed another 400 points. Because it took a month, the ride did not create the thrill that the Big Shot did, but it still churned my stomach. And just like the "Big Shot" the market began and ended at almost the same spot albeit slightly lower.

As always, our friends in the media are more inclined to spin a story to their liking emphasizing the short term or a longer time period depending on what mood they are in. If we understand the mood, the media can be our friend as well as foe. The headline for the Money & Investing section of the Wall Street Journal printed on April 1^st was "Trying to Get Up Off the Mat" which sounds positive, but included the following;   "After the beating that the stock market took during the first three months of 2008....The first quarter was one for the history books....and continues with "Over the past three months, the Dow lost 1001.93 points, its largest first-quarter point decline in the history of the index. Meanwhile, the five months of losses on the Standard & Poor's 500-stock index mark that benchmark's longest losing streak since October 1990".   If we were not careful, it would be easy to draw the conclusion that since stock prices are down, they will continue to go down.

We as people want and desire to find some relative point in history that will help us make a decision about the future. As you know, I believe this desire to compare a past period to the present and draw a conclusion that the future will be the same "as last time" for the most part, does not work in the securities markets. Security prices look into the future.    When events take place that will impact the future cash generation of corporations, the markets will react within minutes of the event. Most events are company specific, however, as we have seen with the volatility last month, major economic events take place that can impact all stocks. The fact that the S&P 500 has had the longest losing streak since October 1990 and the Dow' largest quarterly point decline in history will have absolutely no bearing on what the S&P 500 will do in the next five months.

The next five months will be ruled by the markets anticipation of economic growth, interest rates, and company specific items. And in this respect, given the Federal Reserves aggressive actions, the firming of the asset backed securities markets, the continuation of global growth and that corporate earnings should provide positive comparisons in the next two quarters relative to the last two quarters gives us the impression that stock prices will rise.

The Fed - Bear Stearns - The Fed - Paulson - UBS

The March roller coaster ride was directly related to the perception that major economic events took place that will drive future growth of capital. Before we get into the specific I'd like to take you back in time a few years and provide some details of the financial engineering that took place that helped create this mess.

Late in 2004 a group of 50 traders and lawyers gather around a conference table in Deutsche Bank's Wall Street office, led by Greg Lippmann, a 36 year old Deutsche Bank trader. His group of 5, as they liked to be called included Lippmann, 32 year old Todd Kushman from Bear Sterns, 34 year old Rajiv Kamilla from Goldman Sachs, and one representative each from Citigroup and JP Morgan. As Mark Pittman from Bloomberg stated, There goal was to create a "new standardized contract that would allow firms to protect themselves from the risk of sub-prime mortgages, enable speculators to bet against the U.S. housing market, and help meet demand from institutional investors for the high yields of loans to homeowners with poor credit." In other words, their goal was to create a cash cow for Wall Street from the booming real-estate market. I've stated this in the past, and will continue to state it in the future. Wall Streets only goal in the real-estate market is to find a way to take your money and transfer that money to them. That has once again been proven by the creation and ultimate turmoil that this group of 5 began just a few years ago. This group did not create the home-equity bond business. That had been around for many years. What they did was create a standardized "synthetic" instrument, or derivative, that would allow for the leverage of a small number of sub-prime mortgages into bigger securities. All this became legitimate when the International Swaps and Derivatives Association jumped on board with set terms for dealers. Once this was done, the rating agencies jumped on board and the biggest mortgage underwriters in the business, Lehman Brothers, Merrill, Bank of America and Morgan Stanley demanded their share of the fun. Once everyone was on-board, the leveraging of sub-prime mortgages took off. The end result would create hundreds of billions of dollars in losses. Its nice to know that greed can be rewarded properly. In their greedy search for profit the CEO's of Citigroup, Merrill Lynch, and UBS have lost their jobs while Bear Stearns is no more.

The Fed

The good point in March is that all of this is now out in the open. The risk to the world's economies is no longer being addressed with Adam Smiths invisible hand. Up to this point the Fed's actions have included aggressively lowering interest rates and offering some additional lending where needed. The move they took to create the March 11^th rally went quite a bit further. They created the Term Securities Lending Facility making $200 billion available to lend for up to 28 days against mortgage-backed securities. This action alone added some stability to our financial system. Banks are required to maintain a minimum amount of capital to stay in business. They are also required to mark-to-market their investments. When prices decline on securities, even if the bank is collecting income and has no reason to sell the securities, our regulations require them to value the securities at whatever the market is willing to pay as of that day. The Fed's actions placed a value on high quality AAA rated mortgaged-backed securities above the current market price. This action added some certainty to an uncertain situation and the market reacted positively.

Bear Stearns

This same week in March, with the aggressive Fed action only lasting one day, our roller coaster ride started its free fall, ending on Friday the 14^th with a 200 point decline. The main culprit was the 85 year old and fifth largest investment bank in the world Bear Stearns, who was under extreme financial pressure. Their share price dropped from $63 on Monday to $30 on Friday. On the 14^th they announced that they were turning to J.P. Morgan for a 28-day loan to keep them in business. It seems Bear Stearns was awash with worthless sub-prime paper and on the verge of having to file bankruptcy.

This brought in the Federal Reserve who quickly went to work with over 200 individuals from J.P. Morgan Chase & Company to divert a worldwide melt down of the markets. In an emergency meeting on Sunday, March 16^th the Fed voted to authorize a $30 Billion loan against $29 Billion of Bear Stearns assets so that J.P. Morgan could buy the company and save it from bankruptcy. As Mr. Bernanke stated in his testimony to Congress on April 2^nd, the Fed agreed to the loan "to prevent a disorderly failure" of the company and the "unpredictable but likely severe consequences of such a failure for market functioning and the broader economy." Their action was necessary. Since then, the public has been awash with "you bailed them out, how about me?" Our knowledge of the inter-reaction of the financial markets to our own individual lives is limited. The bail out of Bear Stearns was not taken to benefit a few on Wall Street. The Fed's actions were taken to benefit the average person. This may be hard to understand, but over 50% of all Americans own common stock either directly or through their retirement plans. Almost all Americans at one time or another require a loan from one or more financial institutions. A breakdown of the markets and the lending institutions would have a direct and immediate impact on millions of Americans and their families. There is a direct relationship between how we perceive our own financial security and our desire to invest in the future. A melt down would rapidly flow through our economy with devastating impact on jobs and economic growth.

The Fed

Even with the bailout of Bear Stearns, the markets reacted on Monday the 17^th with fear that Bears demise would flow through to others financial institutions and the meltdown would domino to others. This was quickly diverted on the 18^th with the Federal Reserve again giving relief with a large ¾ point cut in the Fed Funds rate. This cut in rates and the earnings report of Goldman Sachs released on the same day soothed the fear and once again created a positive 400-point day. Our roller coaster ride was coming to an end. I for one will look back at March as being an extremely important month for the markets. A few of the major problems were disclosed and addressed. This is the beginning of the healing process. Before we can heal we need to know and accept our illness. It seems the Fed, our citizens, and our corporations, and for that matter the rest of the world's developed nations, have recognized the severity of the problem and are taking healing actions.

Paulson

Our federal government, which regulates the financial services industry, has also accepted some responsibility for the current state of the industry. On the last day of March our Treasury Secretary Henry W. Paulson Jr., launched the administration's efforts to transform the financial regulatory system. Through their statements they have admitted that the current approach is outdated and in need of change. The plan released would realign the current regulatory agencies into three.   This is how Sec. Paulson described them; "a regulator focused solely on market stability across the entire financial sector, a regulator focused on safety and soundness of those institutions supported by a federal guarantee, and a regulator focused on protecting consumers and investors."

He goes on by saying that the nation needs a regulatory framework "designed for the world we live in, one that is more flexible, one that will better protect investors and consumers, and one that will enable U.S. capital markets to remain the most competitive in the world."

I for one would like to see a reduction in regulation, however, if a reduction cannot take place, an overhaul is surely needed. We know that any real change will require acts by Congress. With that in mind, the plan outlined will probably not have much of a chance in becoming law. The recognition of the failure of current regulations to protect average Americans is a real positive and is one more step toward firming the current market, promoting confidence for the future, and giving hope that the most difficult periods for the economy are over. We will surely find out.

UBS

You probably wonder why a discussion of UBS is warranted. UBS AG is one of the world's largest financial services firm. They are by far the largest wealth manager in the world, have a huge investment banking and securities firm and are one of the largest global asset managers in the world.  The reason is that the markets response to their earnings release on April 1^st is one more indicator that our roller coaster ride is coming to an end. On April 1^st UBS released to the public a $12 Billion operating loss. They took a $19 Billion write off to bad debts related to their sub-prime mortgage investments, they indicated in their statements that their business model is a failure and had to be overhauled.   By admitting failure, the steps needed to heal will be taken. The reason the market responded with a 400 point positive move was not because of the failure, but because the firm was able to raise over $15 Billion from a consortium of banks with just a slight premium to market interest rates to shore up their balance sheet. This would not have been possible last month.

The Last Supper

As I write this Kathy is on her way to visit our daughter's family in Orlando, FL after spending a couple of nights in Savannah. Our family has affectionately adopted the name "The Last Supper" for a get-together meal before anyone leaves on an extended trip. It started a number of years ago close to the Easter holidays, hence the name, when I was off on one of my many competitive motorcycle events. Riding a motorcycle is full of uncertainty and when combined with an endurance aspect can be considered somewhat dangerous. Don't worry; I am currently in a self-imposed retirement from these events. The last major competition I participated in was the 2007 Iron Butt Rally that took place last August.   The Iron Butt Rally is billed as the "World's Toughest Motorcycle Competition" and takes place every two years. A documentary was filmed during the 2007 event. I am not sure if it will be broadcast on any cable channel, but I will surely get a hold of a DVD. The trailer can be found here www.abrawizard.com/ironbutt07/.

This last supper took place at a local restaurant. Justin and myself were talking business, which is something that happens quite often. But this time Kathy sternly told us to quiet the discussion and enjoy the meal. This is something I need to do more often. I can only say that Justin has inherited the joy of our business and as he continues in his pursuit of knowledge and experience I may be able to enjoy the meal.

A Big Thank You!

Our business has been growing.   We hope it's because of our consistent application of a conservative approach to managing portfolios. Although our approach in not exciting it is an approach that we believe is the most appropriate for individual investors that have saved a larger than average sum of money. The latest Capgemini Merrill Lynch Wealth Study reaffirms this. The average wealthy individual has more than 65% of their net worth in large and conservative common stocks, high quality bonds and cash equivalents. The figure is larger when it is measured as part of their investable net worth. It seems that as we get wealthy we are more inclined to reduce risk, not increase it.

I may be a bit naïve when I think it's the consistent application of a conservative investment approach that has led to our growth. I do know that our average new client comes from a direct referral from you. This is why I want to give a Big Thanks to all of you who remember our firm and us.

Our newsletter is mailed to both our clients and friends. Last month I received a nice note from Steve Forbes, the publisher of Forbes Magazine, and former Presidential candidate who receives our letter. It simply said, "You sent my morale soaring - thank you!" Steve, thank you for letting us know you enjoyed it. If you know of someone that would like to receive a complimentary copy, please tell him or her to email Justin@andersongriggs.com and we will add them to the list.

Kendall J. Anderson, CFA