A Casino? Really?

It has been exactly one year since Lehman Brothers declared bankruptcy and sparked a financial panic that substantially changed the trajectory of the already sluggish U.S. economy. The spillover effects rippled through global markets and global trade came to a virtual halt. The U.S. economy contracted by roughly -6% in the 1^st quarter and U.S. imports fell by 34%. (Source: JPMorgan / www.imf.org). The repercussions to our trading partners were substantial. During the first quarter Taiwan’s economic activity (GDP) fell -10.2%, Japan -11.7%, German – 13.4%, Hong Kong -16.1%, Mexico -21%, Russia -33.6%. (Source: JPMorgan)

So what was the series of events that precipitated this shock?

I. The Real Estate Peak, Subprime Collapse & Stock Market Peak

In August of 2006, the real estate market peaked. Falling prices put pressure on lenders and by the summer of 2007 the subprime lending market collapsed. In October 2007, the stock market (S&P 500) peaked.

II. Bear Stearns, Freddie & Fannie

By March 2008, reverberations of falling estate prices led the failure of Bear Stearns, a large Wall Street investment bank. Over the summer of 2008, it became clear that the government would need to support mortgage markets as lending was drying out. The stock market was down over 20% signifying a bear market in equities. By September, Freddie Mac and Fannie Mae, two government sponsored lending giants, were placed into government conservatorship.

III. Merrill, Lehman & AIG

As summer came to a close, several investment banks were desperate for cash. Trust among big institutions was eroding and the spigots of capital were shut off. On September 15^th, Merrill Lynch sold itself to Bank of America, the largest bank in the country at that time, and Lehman Brothers, another large investment bank, failed as it could not find a suitor. The next day, to prevent imminent collapse, the government extended a loan of $85 billion to save AIG, the world’s largest insurance company at that time. That same day, a large money market fund ‘broke the buck’ due to its exposure to Lehman. The failure of this money market fund was significant in spreading panic throughout the financial system.

IV. Financial Shock & Capital Injections

What had begun as a housing bust / credit crunch morphed into a full-blown financial shock. Over the next 6 months, the stock market would fall 57% from the peak in October of 2007, representing one of the worst bear markets in history. The government would take extraordinary actions in an attempt to restore confidence in the financial system and inject significant amounts of capital into U.S. banks. The impact of the financial crisis caused economic activity to contract considerably. It now appears that the U.S. economy is on the mend.

V. Aftermath: Impact on Efficient Market Hypothesis

The impact of this event on investors, bankers, regulators, policy makers and academics has been substantial. Alan Greenspan, a former Chairman of the Federal Reserve told congress last October – “Those of us who have looked to the self-interest of lending institutions to protect shareholder's equity (myself especially) are in a state of shocked disbelief.” (Alan Greenspan, Testimony to Congress, October 23rd, 2008).

I was taught in school (I majored in business economics) that financial markets are efficient, rational and inherently stable – a concept commonly known as EMH (Efficient Market Hypothesis). This concept was essentially handed down to me as cutting edge thinking about the way financial markets truly operated. I, among others, thought it was generally correct given the evidence produced by Nobel Prize winning formulas. Some now maintain that the application of these formulas encouraged excessive risk taking (meaning utilizing massive amounts of leverage to purchase mountains of debt instruments) because the data used in these models ignored the possibility of highly catastrophic and unpredictable events, like the collapse of Lehman Brothers which would set-off panic selling of money market funds, a seemingly irrational behavior, or that liquidity might dry up completely in mortgage markets, and not just the market for subprime mortgages.

However, before EMH, a guy named John Maynard Keynes (1883 – 1946), the highly influential economist of his time, believed that speculators dominated markets, were prone to exuberant mood swings and the whole shebang was essentially a giant casino. (Krugman, NYT, 9/6/09)

One of most interesting things about Keynes was he was well known as a speculator as well as a respected academic. I think if anything results from this crisis is that people will dust off some of Keynes’s old books and see if he still has anything to add to the conversation.

Written by Jason McMillen, Chief Investment Strategist, PPWM

Prognosticating

I watch Bloomberg television everyday. It is something that plays in the background as I work. The primary reason is because I like to know what is going on with the economy and financial markets, and I like to hear what other professionals and pundits are saying about the markets. It is called infotainment.

After thirteen years in this business, what I have learned is most people do not have any special insight on the direction of economy or financial markets. In fact, many so-called experts are either too bullish or too bearish. However, there is an old adage on Wall Street that ‘If you say the same thing for long enough you will eventually be right.’

When I sit down with clients many of them want me to look into a crystal ball and tell them what I see. What I tell them is few people, if any, can accurately predict the future. If there are any absolutes, it is to ‘Expect the Unexpected’ which is a magnet on my refrigerator (next to my ‘Take a bath in the real estate market with Mr. Hou$ing Bubble’ magnet).

So why make any predictions or forecasts if it is a seemingly futile exercise? When it comes to investing all of the old pros provide the same advice which is -- 1) develop your own ideas, 2) have some convictions, 3) admit when you are wrong.

Below we have developed some of our own ideas that we often discuss with our clients. Please take them with a grain of salt as the following disclaimer warns:

All estimates, opinions and views expressed are our own and constitute our best judgments as of the date of this podcast or email and may be subject to change at any time without notice. These opinions and views are made under conditions of great uncertainty and there is a good possibility that our judgments could be completely wrong. However, we hope for your sake and ours that we are more right than wrong of which there is no guarantee.

The PPWM Outlook Fall 2009

A) The global economy is nearing a trough in the business cycle marked by the early phase of a cyclical bull market in financial markets.

B) Coordinated global fiscal and monetary stimulus provides a positive environment for investors.

C) Global interest rates will remain low for a significant period of time as central bankers work aggressively to stimulate risk taking behavior and economic activity.

D) We are in a long-term bull market for commodities, driven by new demand from emerging markets.

E) The developed economies will grow slower than emerging economies.

F) Companies in the developed world that can sell products into the developing world are attractive.

G) The rest of the world is geared toward selling consumer products to the U.S. consumer. They have a huge stake in the revival of U.S. consumption.

H) The U.S. economy and the consumer are resilient and will be highly adaptive to the headwinds they face, despite opinions to the contrary.

I) When (assuming) the global economy starts growing robustly again, inflation will come back quickly.

J) U.S. unemployment rates may not come back down in the near-term as the U.S. economy must make a tectonic shift from the hyper-activity of building automobiles, houses, condos, strip malls and office buildings – to doing something else – at least for the next 5 to 10 years.

K) The fiscal deficits of the U.S. government are unsustainable and highly problematic without serious sacrifices.

L) Industrialized governments have made significant promises to their retirees that are significantly underfunded.

M) Higher taxes are on the horizon.

N) Financial markets still have significant negative exposure to commercial real estate assets that could be disruptive to economic expansion.

O) The government may to have to make additional capital injections into financial institutions in order to absorb future losses due to write-downs associated with commercial real estate (which have not yet been taken). Such injections may destabilize financial markets once again.

P) A multi-year bull market may take stock market indices back to old highs, but a return to the good old days like the 1980s and 1990s where indices rose 15-fold is probably not in the cards until the ‘structural headwinds’ mentioned above have been addressed. This may mean another decade of volatile markets similar to the 1960s and 1970s.

Investment Implications

Based on the outlook above, we believe investors may need to be more proactive and nimble than they have been in the past. This may require considering new investments ideas, timing strategies and examining yield as an important slice of total return. We will continue to make investments in companies with exposure to basic materials (commodities) and emerging markets, either through the purchase of fixed income or equity instruments. In addition, we want exposure to investments that benefit from an improving global economy or can benefit from an inflationary environment. If you want specifics, we encourage you to contact us. These are our prognostications -- for now.

Written by Jason McMillen, Chief Investment Strategist, PPWM