Saturday, November 22, 2008

collateral crisis

... we believe this will prove to be a good time—and maybe even a great time—to invest for people with time horizons beyond a year or two. While there’s no way to know where the market will be in the short term, many conditions are in place for better performance. More directly, we believe the market at these levels represents substantial value for long-term investors.

Let’s start at the top with a brief take on recent events. Clearly, there’s been no lack of commentary on what’s happened over the last 15 months or so. The way we would characterize it, in the mid 2000s the world enjoyed a strong growth phase led by global expansion, simultaneous with relatively low volatility. The low volatility and higher asset prices encouraged investors (including financial institutions) and consumers to get comfortable with greater leverage. Increasing leverage in a low-volatility environment makes sense on some levels—for example, it helps boost returns for investors and increases affordability for consumers.

The problem comes when the system overreaches, which started happening in 2006 and for sure in 2007. This overreaching was most pronounced with the U.S. housing market.

So we are now in a substantial unwinding process. And this unwinding process means we have a collateral-based, not a liquidity-based, crisis. Specifically, a collateral-based crisis is marked by a very devastating positive feedback loop: an asset price drops, leading to a margin call, leading to asset sales, leading to a further drop, leading to another margin call, and so on. What’s key is governments can solve liquidity-based crises with injections of liquidity, as we saw in 1987 and 1998. Collateral crises, in contrast, require more action.

Collateral crises are much more damaging and prolonged than liquidity crises, and require substantial natural deleveraging and government action to encourage lending again. The good news is that governments around the world are on the case. And while there have been missteps, and there will be unintended consequences we have yet to recognize, the global government mobilizations suggest this downturn will be more akin to the early 1970s, early 1980s, or early 1990s than to the Great Depression.

... we looked at the distribution of stock market returns since 1926. In that time, the arithmetic mean return has been a shade under 12 percent and the standard deviation about 20 percent. So if the market finished 2008 at current levels, it’ll be well over a two standard deviation event—something you’d expect once every 40 or 50 years. Indeed, the year-to-date 2008 returns rank it among the worst in the past 85 years, behind only 1931.

And just to put a finer point on this volatility, October 13 and October 15 represented two of the five largest absolute changes in the market since World War II. In other words, of the prior 17,000 trading sessions, two of the biggest five days happened within three days during the week of October 13, 2008. It would not be unreasonable to expect more large moves, akin to earthquakes aftershocks.

... where might we go from here? The first thing to recognize is the stock market is a discounting mechanism. In times of extremes, it is important to carefully distinguish between fundamentals—which will be challenging for the foreseeable future—and the expectations built into asset prices. Dwelling solely on fundamentals, a natural tendency, encourages investors to overlook the way to make money: finding gaps between price and value.

... you can make a decent case for the market based on dividends alone. The current dividend yield on the S&P 500 is only about 80 basis points below the yield on the 10-year Treasury note (see Exhibit 3). You have to go back to the early 1960s to find a similar relationship. 6 If you add in share buybacks, the yield is over 300 basis points above the 10-year note yield, and that’s with buybacks down sharply this year.

... One of the ways to think about environments like today is to step back and take a normalized view of things. Exhibit 5 shows the rolling 10-year returns for large-capitalization stocks. Over the past century-plus, the market has tended to bottom out around zero percent rolling ten-year returns. That happened in the 1930s and 1970s, and that is where we are today. The rolling 10-year figure is worth examining for psychological reasons, too. If the average investor is in a mutual fund, they have lost money after taking fees into consideration. Further, most investors lose an additional 200 basis points due to bad timing. So the bottom line is on a dollar-weighted basis, the average investor has been down substantially in the U.S. stock market in the past decade. That is very psychologically damaging.

We also place significance on Warren Buffett’s actions and comments.

what appears most significant is the juxtaposition of his November 22, 1999, Fortune article and his October 17, 2008, New York Times commentary. Buffett very rarely takes the initiative to comment on the overall market, but he did so in these articles. In the 1999 article, within four months of the market’s top, he suggested that real returns from the market going forward were likely to be about four percent, and if he was wrong, he thought his number was likely too high. In the past decade, we’ve been very close to a zero real return.

In October 2008, he wrote that “the market will move higher, perhaps substantially so, well before either economic sentiment or the economy turns up.” He also added that he’s buying U.S. stocks in his personal account. His partner, Charlie Munger, echoed these thoughts separately. Exhibit 6 plots Buffett’s market calls on the rolling 10-year returns. He has proven to be reliably prescient.

... To finish, here are a couple of observations from behavioral finance. The first relates to a great piece of research that is very relevant today. In this study, normal people were pitted against people with brain damage in a contest. The brain damage had nothing to do with mathematical or logical abilities, but dealt with the emotional seat—ability to feel fear, greed, anxiety and so forth.

The contest was simple. Each participant was given 20 dollars, and for 20 rounds had a choice to do one of two things: they could either keep their dollar or hand the dollar to the researcher who then flipped a coin and paid $2.50 for a win and zero for a loss. So the expected value of handing over the dollar was $1.25.

The bottom line is the brain-damaged participants ended up with 13 percent more money than the normal players. The reason is how frequently people were willing to gamble. Everyone understood that playing made sense, and almost all players started off handing over their dollars. But when the normal people lost a round or two, they often chose to hold on to their dollars in the next round. In other words, normal people forgo explicitly net present value positive bets after they have lost.

This is very akin to today’s environment: most people recognize there is value in the market, but they would rather hold their cash than risk losing again. To state the obvious, the way to end up with the most money is to participate in net present value positive investments, even when your emotions tell you not to.


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