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October 2009

M. Cullen Thompson, CFA

Managing Partner & Chief Investment Officer

Investment Officer The Lost Decade Love affairs, as they say, don’t end

The Lost Decade

Love affairs, as they say, don’t end easily. Yet one has to marvel at the unwavering obsession with US equities. As many 401k participants will attest, the decade of the 2000s has not been kind to investors, particularly to those of the buy-and-hold variety. On January 1, 2000, the S&P 500 stepped into the new millennium at 1,469, nearly 40 percent higher than its 1,060 closing price on September 30, 2009. Accounting for dividends softens the damage, bringing the cumulative loss to 14 percent. But the additional yield is overwhelmed by the 28 percent rise in inflation. All told, the S&P has trailed the CPI by a stomach-churning 42 percent.

"Buy & Suffer " - S&P 500 Index vs. Inflation 40 30 20 10 0
"Buy & Suffer " - S&P 500 Index vs. Inflation
Consumer Price Index (CPI)
S&P 500

Source: Bloomberg

Secular bear markets are more common than most investors believe, as even a cursory glance at the following chart shows. Unlike today, the 16-year stretch of negative real returns culminating in 1982 left many investors disillusioned. Business Week audaciously called for the demise of the asset class with their often-ridiculed August 1979 cover story “The Death of Equities,” believing that the growing disenfranchisement with equities “could no longer be seen as something a stock market rally—however

longer be seen as something a stock market rally—however strong—will check,” given that negative real returns

strong—will check,” given that negative real returns had “persisted for more than 10 years through market rallies, business cycles, recession, recoveries and booms.” Resurrecting interest in US stocks would require not only “years of confidence building,” but also a “massive promotional campaign to bring people back to the market.”

High inflation, interest rates and energy prices were the affliction of the day. Lacking imagination, the editors could not foresee the ensuing bull market whereby share prices (and valuations) would be sent firmly into orbit. Between 1982 and 1999, US stock prices rose by a factor of thirteen, marking the most remarkable run of annual increases in the history of the American republic.

Despite the wealth destruction of 2008, no promotional campaigns are necessary to reinvigorate interest in equities in 2009. Sensing an opportunity following the worst contraction in US stocks since 1931, investors—conditioned to buy the dips—appear hell-bent on recovering their retirement-wrecking losses. In doing so, they are scooping up shares with little regard to valuations, prospective revenue growth, the developing fiscal crisis or more generally the


fallibility of policies of adding debt onto already unsustainable levels of debt.

Persistence, we suppose, is the American way. But prudence, we believe, would be better placed in the investor psyche. For in no way did the trough in equity prices this past March resemble the multi- decade opportunity originating in ’82, a time when stock prices were low and their accompanying dividends high.

Shortly after Business Week’s ill-timed article went to press, a sort of macroeconomic tranquility fell over the globe—a nearly three decade period of lower inflation and interest rates, growth-inspiring demographics, deregulation, globalization, as well as technological advancement. “The Great Moderation,” it was later called, a self-congratulatory term coined by central bankers themselves. Echoing former Treasury Secretary Andrew W. Mellon, who in 1928 claimed that, “we are no longer the victims of the vagaries of business cycles. The Federal Reserve System is the antidote for money contraction and shortage,” Greenspan, Bernanke, Geithner and Yellen, along with their other FOMC committee members, ventured the notion that it was their “credibility” and abundant talents at manipulating interest rates that had accomplished what none of their predecessors had. If central banking was a science, they had mastered it. From now on, we would have the booms without the busts. And with the road of never-ending prosperity wide open, excessive leverage, sky-rocketing asset prices and a little irrational exuberance were of no material concern.

But “Leverage,” as James Grant, editor of the eponymous financial newsletter has eloquently described, “is the Hamburger Helper of Finance. It makes a little capital go a long way, often much further than it safely should.”

In leading up to the current crisis, private sector leverage went too far. And by socializing finance, the authorities transferred many of the liabilities of the

the authorities transferred many of the liabilities of the private sector to the public balance sheet,

private sector to the public balance sheet, and in doing so, accelerated the possibility of a fiscal crisis.

Governments, as history has proven, get into debt without any intention of ever getting out. Well aware of this awkward fact, our founding fathers vowed to prevent it. In a letter to James Madison in 1789, Thomas Jefferson asked whether “one generation of men has the right to bind another,” ultimately deciding for himself that “no generation can contract debts greater than may be paid during the course of its own existence.”

Washington today operates under a different moral compass. But should restraint soon find its way to Capitol Hill and the current double-digit budget deficit be reduced to a seemingly manageable 5.0 percent, outstanding Treasury debt, now footing to 60 percent of GDP, will continue its inexorable rise towards 100 percent—a level which, in the words of Standard & Poor’s, is “incompatible with a triple-A rating.” Given that the majority of our deficit funding comes from foreign investors, the US is in a precarious situation. How long can we continue to rely on the kindness of strangers?

Excessive leverage, whether in the public, private or financial sector is the key ingredient for identifying an economy underpinned by quicksand—one that is increasingly accident-prone and dependent on the fickleness of confidence in order to stay afloat.

In their recent book, This Time is Different¸ Kenneth Rogoff, former Chief Economist at the IMF, and Carmen Reinhart emphasize this point as they chronicle Eight Centuries of Financial Folly, which also serves as the subtitle. In the preface, the authors highlight one common theme that preceded the vast range of crises analyzed: “excessive debt accumulation, whether it be by government, banks, corporations, or consumers” is what often poses much greater systemic risks than imagined.

Complicating the investment environment today are a number of complex, interrelated and hard-to-predict issues, specifically the tug-of-war between inflation


versus deflation, rising unemployment, potentially higher interest rates resulting from exploding public debt, the forthcoming refinancing wave of both residential and commercial real estate and the rapid deleveraging of the American consumer, the de facto engine of growth for a highly imbalanced US and global economy.

The threats of imminent economic collapse and the failure of another major financial institution have thankfully passed (largely as a result of the “To Big to Fail” doctrine). But in guaranteeing so, the authorities removed one form of systemic risk and introduced another. Namely, they have threatened the credibility and financial stability of the United States, as well as the uncollateralized dollar it prints.

Benjamin Graham and David Dodd, godfathers of value investing and authors of Security Analysis, believed that since the future is unpredictable, a margin a safety is required when putting capital at risk. Buying an asset at a price below its intrinsic value provides a natural defense against general uncertainty. Both would likely blush at the premium multiples presently attached to the vast majority of equities.

Predicting the Death of Equities in the US would be as nonsensical now as it was in 1979. To be sure, opportunities are selectively available now and will be broadly so in the future. But as the previous charts illustrate, equity prices do not rise unconditionally from every starting point. And as those who paid peak multiples in 1999 painfully learned, what you buy (i.e. quality) and the price you pay for it (i.e. valuation) matters. Today, the S&P is priced for perfection. But what if the future delivers something short of it?

But what if the future delivers something short of it? Portfolio Review & Strategy Debt, we

Portfolio Review & Strategy

Debt, we informed our clients earlier in the year, is the new equity. If there was a silver-lining of the credit crack-up of ’08, it was the astonishing opportunities in highly dislocated fixed income markets left in its wake. Investment grade bonds, convertible bonds, TIPS and mortgage-back securities, all sporting high yields and low prices, were in our sights. As for US government bonds, we were short.

At 500 basis points over Treasuries, investment grade corporate bonds were on offer at spreads not seen since the Depression (the Great one that is), implying default rates that, for all intents and purposes, were simply unfathomable. Treasury Inflation-Protected Securities were discounting multiple years of deflation while converts, nearly annihilated in the forced deleveraging of last year, were trading below their straight bond equivalents (i.e. assigning no value to the embedded option to convert into equity).

no value to the embedded option to convert into equity). Equity-like returns with the security of

Equity-like returns with the security of a bond—a rarity in supposedly efficient capital markets—was our motto. At the beginning of 2009, we decided, our focus would be high in the capital structure.

On the opportunity, we were correct—all sectors have enjoyed double-digit gains. Investment grade bonds snapped back to rationality, mortgage-backed securities have rallied 20 percent, while convertible bonds have gained over 30 percent.


Our estimated time horizon, however, was admittedly off. Expecting a multi-year opportunity, we were rewarded in just a few months. Such flagrant mispricings don’t usually persist long, and nor should they on the back of the most radical reflationary campaign in modern history. “Thank you for the opportunity,” we say to the Great Recession, “it’s now time to move on.”

Within equities, we have been and remain largely underweight, modestly hedged and globally-oriented. Put simply, the rally off the March lows has gone too far too fast, benefitting from increased risk appetite that has driven an unprecedented expansion of P/E multiples. Cyclical rallies in secular bear markets can be frequent and pronounced, as even a passive observer of Japan over the last twenty years or the US in the 1930s would note. Our long positions are high- quality and largely exposed to secular themes, specifically, emerging markets, Asia and energy.

themes, specifically, emerging markets, Asia and energy. Our hedged nature benefitted us considerably in the first

Our hedged nature benefitted us considerably in the first quarter of the year. As the S&P fell 25 percent, bringing its peak-to-trough decline to nearly 60 percent, our portfolios were never down more than single-digits (and in many cases, were positive). This preservation of capital allowed us to deploy assets opportunistically. Yet our cautious positioning has fortunately not detracted from overall portfolio returns as equity markets began to recover in March, thanks largely to manager and security selection, which

thanks largely to manager and security selection, which has been a tremendously positive contributor throughout the

has been a tremendously positive contributor throughout the year.

Indiscriminate selling in late ’08 and early ’09 led to very favorable conditions for active management. Heading into the year, we felt that many of our longer term, core equity managers had enormous embedded value in their portfolios. As it turns out, we were correct. As of writing 1 , within domestic equities, our two long-only managers appreciated by 30 percent and 51 percent, respectively. Our internationally-focused allocations, representing the majority of our equity exposure, performed equally as well (developed international: +24 percent, Asia-specific: +40 percent and emerging markets: +69 percent). Additionally, we made two profitable tactical allocations to the energy space (energy services: +62 percent and exploration & production: +46 percent).

Over the course of the year 100 percent of our managers and equity positions outperformed the S&P—a perfect batting average that is certain to be the exception rather than the rule—and did so by a margin that was more than sufficient to offset our modest hedge on the index, which was used to remove some unwanted market directional risk (allowing us to isolate more of our returns into the skill of our managers).

We maintain a position in gold, which we believe to be an essential form of insurance in a highly-imbalanced world. Appreciating 20 percent year-to-date, gold remains, for the most part, inversely correlated to the level of confidence in governments.

We are also still carrying healthy allocations to cash— the ultimate deflation hedge—despite the paltry returns available. Our cash positions largely reflect the lack of value in many asset classes and our belief that better opportunities possibly lie ahead. Risk, as always, is to be taken in a measured fashion and balanced with the potential reward.

1 October 20, 2009


Although the recession may be over, the recovery has been policy-induced—the result of transitory subsidies, stimulus and gimmicks. It was, to a large extent, engineered in Washington. Organic, private sector demand, the hallmark of sustainable economic expansions, remains weak.

All recessions are not created equal. There are business cycle recessions and balance sheet recessions. The former are more common and the latter more damaging in their severity and duration. The Great Recession was a balance sheet recession. Higher savings, less debt and lower consumption will be the new reality, making it hard to envision the sustainable vigor necessary to drive corporate profits enough to justify today’s lofty valuations.

Wisdom, it has been said, consists of the anticipation of consequences. The consequences of intervention (i.e. quantitative easing, double-digit fiscal deficits, exploding sovereign debt, bailouts, guarantees and the general socialization of risk) will be of the intended and unintended kind. We will be anticipating both, hopefully able to navigate what is certain to be an uncertain world. Flexibility, therefore, remains our primary advantage, firmly acknowledging that deflationary aftershocks following a post-bubble credit collapse are common and often lasts years, not months. “Investing,” as PIMCO’s Bill Gross recently remarked, “is no longer child’s play.”


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