At some point, we believe investors will begin to anticipate recovery, and the fear that has driven so many individuals to hold cash will subside; the fundamental attractiveness of equities will become apparent, and market prices will better reflect fair value.

To cut to the chase: 1) we think this process has begun; 2) there remains plenty to worry about, although the worst-case outcome looks less likely to us each day; 3) even given the sharp recent recovery, we can find plenty of undervalued, strong businesses to hold in our portfolios.

If the market’s rapid turnaround surprised most folks, it’s also worth noting at least two “unsurprising” features of the past few months. The first is the rude awakening that overly conservative investors experienced in the Treasury market. As we warned at year end, massive cash flows into seemingly-safe U.S. Treasury bonds represented “bubble-like behavior” as prices soared and yields dropped to absurd levels:

We cannot embrace the investment proposition of shifting funds to long-term Treasuries where the best-case outcome delivers something close to zero….to gravitate to the “risk-free” asset class at this point runs counter to the opportunistic sensibility our firm has exercised over three decades.

Sure enough, holders of long-term Treasuries have been burned. Since late 2008, yields on the 10-year Treasury nearly doubled from 2.1% to almost 4.0% (recent yield: 3.7%), and it’s jarring to think that the asset class many presumed to be the “safest” of all – particularly during a period of rapidly declining fundamentals – could generate meaningful losses of principal (the worst six-month performance in over three decades). This example certainly serves to reinforce our own long-held conviction that momentum-driven strategies, even for the “safest” asset class, carry great risks. Here, the “flight to safety” was more like a road trip to Vegas. Even the surest bet, if priced high enough, is at risk of painful loss.

The other non-surprise in recent months has been the unprecedented government response to the crisis itself. There is little debate that the credit crisis exposed some very significant structural weaknesses in our financial system, including various regulatory structures and early-warning mechanisms. But the response to the crisis, conversely, has been creative, substantial and characteristic of politicians and regulators determined to do anything and everything necessary to save the system (and their own jobs). The Fed and Treasury are validating an old adage: if you have a hammer, every problem looks like a nail.

Some are not comfortable with the policy implications of all this activity. There are plenty of issues that will be debated for years, including the decisions to intervene in the collapses of Bear Stearns and AIG (but not Lehman Brothers). Or the legality of using the TARP funds for wider purposes than legislatively intended. Others will also second-guess the decision to take control of GM while other businesses with similar challenges were left in the cold. On an entirely different level, the government’s massive stimulus program, as well as its increasing influence in energy policy and health care reform implies a level of government intervention that many would have never imagined even a few years ago. For those Rip van Winkles more accustomed to limited government and free markets, today’s wake-up call asks: “now how did all of THAT happen?”

As they say, the genie cannot be put back into the bottle so easily. Our own views on particular government policies are less important than how the economy and markets digest any significant changes. In the near term, the stimulus package is expensive, the financial bailout has led to money creation, and entitlement spending is likely to rise at a faster pace. These factors raise new fears about long-term, structural inflation. Similarly, the shaken faith in financial markets implies much more reliance on government decision-making amidst an ever more entangled and complex world. The challenges, for sure, appear daunting. But we also believe the markets are already incorporating a great deal of this information into current prices: Treasury yields are up and stock prices remain depressed even after the recent recovery. Skepticism is high as evidenced by massive reserves of cash in money market funds and other near-cash instruments.

We certainly do not have all the answers, but we are also not frozen. During such a period of profound potential change, one must fight the tendency to search for the nearest hiding place, if only because the lack of certainty creates its own set of opportunities (as recent months have shown). We also recall the wise words of one of our partners who once argued – sensibly – that investment goals are rarely achieved by betting on low-probability, worst-case outcomes. Even with today’s elevated political rhetoric, a likely conclusion to the entitlement spending debate will undoubtedly include provisions to address long-term inflation concerns, if only because the bond market’s vigilantism casts such a long shadow. Neither politics nor markets operate in a vacuum. Much change is already anticipated by the market, and any progress on addressing some of the long-term structural issues we’ve mentioned would be a meaningful, positive surprise.

In the meantime, we continue to emphasize in our portfolios what we believe are the strongest businesses which, thankfully, remain plentiful and attractively priced. Benefits of this strategy, as we explained in recent letters, include: 1) survivability in case recovery takes much longer than anticipated; and 2) the additional financial flexibility such firms can use to improve their relative market positioning and future profitability (at the expense of weaker competitors). We think this emphasis has played an important role in our improved results in recent quarters, and we believe more opportunity lies ahead.

We have also conducted a top-to-bottom review of our intrinsic value estimates for all of our holdings, leading to extensive adjustments in our targets. Part of the rationale for this move relates to the dearth of recent merger and acquisition activity: although there has been some pickup in the number of deals in recent months, the difficult financing environment has provided fewer recent benchmark transactions to confirm our internal valuation work. But another justification for some newfound conservatism considers the changing policy environment we just discussed (and incremental uncertainty regarding future profitability and growth). While these intrinsic value reductions have had no material impact on our portfolio construction process – current price/value gaps remain wide and attractive for the vast majority of our holdings – the additional caution provides us with even greater conviction that our portfolios remain attractive even if the policy outcomes are more significant than we think likely.

While our conviction regarding the long-term opportunity is quite high, we recognize that the short-term direction of the market likely hinges on the interpretation of some very esoteric data, including second-derivative calculations (e.g. things becoming increasingly less bad) which we find overdone and distracting. While the massive effort to forestall a deeper banking crisis has yielded tangible results, it’s tougher to discern a clear improvement in fundamental trends across other sectors that would signal a definitive end to the crisis. Much of the economic data we all see reported each week represents old information, and so we will not be surprised to see continued weakness in reported sales and profits (as well as, for example, GDP and unemployment) for quite some time. We certainly expect to see tangible improvements, but the timing of recovery remains a mystery, and we are reluctant to play a short-term guessing game. Like every other economic cycle, we believe this one will also turn. Suffice it to say that we do see the elements of recovery falling into place – narrowing credit spreads, rising bond and equity issuance, lower levels of inventory, cost-cutting, etc. – and our portfolios are positioned to benefit from cyclical recovery in the coming years. Recent performance trends – so far, so good – are encouraging.

Edward S. Loeb
quarterlynews@harrisassoc.com