In reviewing the title of last quarter’s letter, it would be fair to say that “Turmoil” has extended into its sequel: the markets remain gripped by the repercussions of one of the largest failures of risk management ever witnessed. Three months ago we described how the pundits were outbidding each other regarding the magnitude of bank-related accounting writeoffs, and while that game remains at the forefront, the breadth and depth of the credit crisis has worsened and seemingly punched the economy in the gut (or maybe not – more on that later). In any case, the list of high-profile crisis victims has certainly expanded from holders of low-rated mortgage bonds to the ostensibly better protected investors in auction-rate securities. And then there are the shareholders of Bear Stearns, who win the “sacrificial lamb” honor of this episode as the Fed engineered an unprecedented bailout (even while arguing it doesn’t really do such things). We recognize that few outsiders will shed a tear for Bear: they played as aggressively as anyone in the mortgage market, they operated with a thin slice of capital, and they had plenty of competitors. But we have a tough time exhibiting Schadenfreude when billions are lost, perhaps unnecessarily, while markets are rocked. To the extent anyone out there feels the need to take covert pleasure from observing adverse outcomes, please direct your attention to the dalliances of the former Governor of New York.

The turmoil has been most evident in the large, daily swings in the equity and fixed income markets. As Barron’s recently reported, stocks have been their wildest in seventy years: over one-half of the trading days in 2008 have seen at least 1% moves. Despite some strong rallies throughout the quarter, however, the S&P 500’s nearly 10% decline (and 15% swoon since October) left few investors unscathed. In many ways, the market’s jumpiness reflects great uncertainty regarding the capital adequacy of a number of key financial companies, the linkages among the various players, as well as the Fed’s unprecedented recent actions. But with little fundamental news to confirm the economy’s trajectory, the weakness seems to be driven more by deleveraging and risk reduction than disappointment. Since the crisis started last summer, U.S. equity mutual funds have seen an unrelenting pattern of outflows, with the proceeds ending up for the most part in low-yielding money market funds. We’ve seen this story before (1991, 2002), and the rush to the exit – while providing some temporary peace-of-mind – merely creates a tougher task for the investor who seeks long-term capital appreciation.

The crisis has, indeed, unfolded rapidly. Without parroting the legions of journalists and analysts who each day pound away at the latest “villains” and “victims”, our own views of the cause of this crisis remain simple and unchanged: a prolonged period of market stability, as it usually does, promoted greater risk taking. With rising profits and evidently clear sailing – and the need for a few extra basis points of return – highly leveraged markets were susceptible to any dislocation (which the housing industry easily provided). There certainly were plenty of “enablers” in this process: the investment banks, the mortgage companies, the rating agencies, the Federal Reserve (i.e. Greenspan), and so on. We cannot recall an episode when so many fiduciaries apparently committed so much capital and reputation using such little common sense.

Today, the crisis is primarily manifested in an apparent shortage of capital among key financial market players. As the banks, investment banks and other intermediaries have been forced to write down (or provision for) large losses, they have backed away as providers of liquidity and instead hoarded their precious remaining capital. In practice, this has meant more motivated sellers than interested and able buyers, and thus lower prices. From our perspective, however, there is a troubling aspect of much of the writedown activity and the downward spiral it has created: much of it has been driven by several obscure mortgage indices that may bear little relation to the underlying fundamentals they were designed to track.

Without getting bogged down in too much technical minutiae, banks and related institutions have been required to value their financial assets according to SFAS 157 (this rule was just recently relaxed by the SEC), which says that for certain assets that don’t trade very often, a third party reference instrument should be used to “mark-to-market”. This has been the major factor in the large writedowns we’ve seen recently. The concept, in theory, is a good one: market prices should reflect current values a lot better than historical cost. But various reference indices – ABX for subprime loans, CMBX for commercial mortgages – have collapsed in recent months, possibly driven down in price by heavy selling by banks and hedge funds seeking a way to hedge or speculate in the mortgage market. Nevertheless, the collapse in these prices has directly impacted the banks by forcing further writedowns in their portfolios, whether or not the fundamentals of the underlying mortgages justify such moves. For example, as of late March, a version of the ABX that tracks AAA-rated mortgage loans traded at a price that we believe implies about one-half of all such recent loans will go bad. This is a possible but highly unlikely outcome, as it would require delinquencies to multiply more than tenfold from current levels. Yet banks have been forced to use this reference index to value their assets. In fact, the ABX index was never meant to serve such an important purpose, and there are good technical reasons to question its validity (plus, even the firm that created them admits the indices have serious limitations). Yet the process continues, and each required accounting writedown adds further stress and uncertainty to an already spooked market.

While the technical questions about mark-to-market accounting are one source of our own skepticism of the doomsayers’ argument, a more important factor centers on the issue of a U.S. recession and its timing (which is apparently a certainty according to 90% of those polled in a recent national survey). First, let’s be clear that whether or not there is an economic recession, we are undoubtedly seeing a slowdown in conjunction with stresses on our markets. Our own fundamental estimates reflect this slowdown as a component of the typical ups and downs of a cyclical economy. Our investment philosophy, of course, focuses on the long-term intrinsic value of a business, which is typically much less volatile than the surrounding economic environment. With that said, clear evidence of recession is still not obvious: GDP grew throughout 2007, and while we don’t pretend to be economists, there are several reasons to believe 2008 will also show positive growth. Some important macroeconomic factors remain supportive of growth (strong exports and a below-average unemployment rate), and the current and expected fiscal/monetary stimulus appears large and unprecedented in scope (3-4% in various interest rate cuts, vastly expanded borrowing facilities for banks and investment banks and $150 billion in tax rebates to be delivered shortly). So, we think the issue of recession is still debatable. More importantly for our own analytical work, however, we continue to forecast profit and intrinsic value growth over the next two years for the companies we follow. With declining prices for most stocks, this has led to an increase in the price/value gap we seek to exploit, implying an expansion of the investment opportunity for our clients.

Even if recession is upon us, we continue to believe the outlook for equities can definitely remain positive. The historical data shows the prelude to a recession to be the toughest stretch for stocks, while the outlook brightens considerably once the recession is in place. Another related timing factor is the crisis itself: the long history of the stock market shows some great buying opportunities immediately following financial crises. In a world geared to 24-hour news cycles, it’s difficult to remember or place into proper perspective the conditions and feelings during similar episodes. But in fact, the stock market recovered and advanced strongly immediately following: the 1984 collapse of Continental Illinois; the 1987 market crash; the 1995 Peso crisis; the 1998 collapse of hedge fund LTCM; and the bursting of the late 1990’s Tech bubble. In each instance, market analysts and regulators sounded the alarm – the worst crisis ever! – yet initial market declines ultimately reversed, and the market then advanced handsomely, propelled by improving fundamental profit performance, bargain hunters who recognized undervalued opportunities in the midst of investor panic, and of course governments and central banks who tend to do anything in their power (at least since the 1930s) to promote growth over all else.

The credit crisis has been unnerving, but we are not unnerved. We humbly admit that the breadth of the problem has surprised many (a year ago, did anyone really think twice about cash-equivalent investments like auction-rate preferreds?), and we see broad pessimism among investors and analysts. The coming months and years will belatedly deal with the structures and individuals who helped foster excessive risk taking, and more regulation is certain. But the current state of the markets – and the health of thousands of individual companies – demands a reconciliation of the fundamental facts and the demeanor of investors. Rather than the pessimistic certainty that most seem to see, we see plenty of room for disagreement on a number of topics – the impact of mark-to-market pricing, the timing and magnitude of an economic slowdown, as well as market opportunities that seem to so far swamp the capability and available capital of investors. With scary headlines and a rough start to the year, we understand the temptation to retrench is high. But from our vantage point, the long-term fundamental story remains intact; the opportunities grow each day, and the current atmosphere sets the stage for brighter days ahead.

Edward S. Loeb
quarterlynews@harrisassoc.com