Farewell to all that

“A fool and his money are lucky enough to get together in the first place.”

Gordon Gekko (Michael Douglas) in the film ‘Wall Street’.

First, a happy new year to all readers. There was a fitting circularity to 2008, in that a year that began with the largest apparent fraud in banking history (Jérôme Kerviel’s €5 billion loss at Société Générale) also ended with it, in the form of Bernard Madoff’s self-confessed Ponzi scheme and losses that have been stated at approaching $50 billion. Kerviel showed that investment banks were not necessarily the most competent handlers of risk – a point that Bear Stearns and Lehman Brothers, and the effective termination of Wall Street as a private entity, later underlined. Bernard Madoff in turn showed that those local councils with deposits in Icelandic banks did not have an absolute monopoly on credulity, nor on negligence in conducting appropriate due diligence – supposedly sophisticated institutional investors were just as capable of being taken for a hugely expensive ride.

There was a circularity, too, to the circumstances of the Madoff fraud. Just as last year’s spike in Volkswagen stock was a modern echo of the much earlier 1920 ‘corner’ in the stock of the Stutz Motor Car Company, so Madoff himself bears more than a token similarity to Richard Whitney, whose downfall after the Great Crash of 1929 is also ably told in John Brooks’ excellent ‘Once in Golconda’ (Wiley, 1999). Like Madoff, Whitney was a member of the Wall Street establishment: he had his own brokerage business, and a seat on the New York Stock Exchange, where he had once been President. Madoff, of course, has his own brokerage business, and is a former chairman of Nasdaq. Having lost money in a variety of speculative investments, Whitney borrowed heavily from friends and family, and finally turned to embezzlement. He ended up serving a little over three years in Sing Sing.

From a year for markets that has already entered the history books, the Kerviel and Madoff scandals also highlight some central aspects of the financial crisis. Trust as a commodity is increasingly hard to come by. As Michael Lewis and David Einhorn point out, the pertinent issue was how little interest anyone inside the financial system had in exposing such stupendous levels of fraud: “The fixable problem isn’t the greed of the few but the misaligned interests of the many.” And the sheer scale of the fraud involved – a scale matched only by the enormity of the financial bailouts from western governments – gives rise to a lingering uncertainty about the value of money in the first place. If so much money can be stolen (or distributed by government fiat, for that matter) with such apparent ease, what is that money really worth ?

The foreign exchange markets (and gold, for that matter) have already started to tell us. Since July last year, Sterling has lost roughly a third of its value against the US dollar. On an annualised basis that equates to a loss of 50%. But the comparison with a seemingly strong dollar only gives one side of the story. Against the Japanese yen over the same period, the US dollar has itself lost 20% of its value. Even without a rise in international trade tariffs (India, Russia and Vietnam have all recently raised tariffs), the threat of competitive de facto currency devaluations looms large over the global economy. And while manipulated currency weakness aids exporters, it comes laden with the heavy possibility of unintended consequences: “Japan should write off its holdings of US Treasuries because the US government will struggle to finance increasing debt levels needed to dig the economy out of recession,” commented Akio Mikuni, president of the eponymous credit ratings agency.

And if any asset class came close to bubble territory in 2008, US Treasuries were it. Three month US T-Bills now yield 0.08%, having at one stage last year traded at a negative yield. The yields of inflation-linked bonds, by contrast, suggest that investors see zero CPI inflation for at least the next five years. Given the extent of the announced fiscal and monetary pump-priming, let alone the Obama pump-priming destined to come, inflation-linked US Treasuries look like the better risk-reward. And better still is the value on offer from investment grade corporate credits. Risk-averse investors uncomfortable with the meagre returns available from cash deposits may well find high quality corporate bonds an acceptable, and comparatively yieldy, alternative. The most cost-efficient vehicles to access them, as ever, will be exchange-traded funds.

Expecting further gains from equity markets this year seems reasonable, not least because a malign combination of governments and banks are practically forcing investors out of cash. Whether those gains are durable is another question. Rather than bet the ranch on black, it makes more sense to remain extremely selective as to equity market exposure. In sectoral terms, what was stunningly out of favour in 2008 is unlikely to work in 2009. That includes banks and financials, homebuilders and construction stocks, and consumer cyclicals. For some time now we have alluded to the one measure above any other that matters for equity investors in the year ahead: the Altman Z Score. Bloomberg defines this rating as follows:  a measure that

“Indicates the probability of a company entering bankruptcy within the next two years. The higher the value, the lower the probability of bankruptcy. A score above 3 indicates that bankruptcy is unlikely; below 1.8, bankruptcy is possible..”

For the technically minded, the Altman Z Score is calculated as follows:

Z –Score = 1.2 x [Working Capital / Tangible Assets] + 1.4 x [Retained Earnings / Tangible Assets] + 3.3 x [Earnings Before Interest and Taxes / Tangible Assets] + 0.6 x [Market Value of Equity / Total Debt] + [Sales / Tangible Assets].

Stocks with high Altman scores will feature prominently in our commentaries as the year unwinds. Where those high scores coincide with sensible defensive sectors, low price / book ratios, low price / earnings ratios, and modest or no debt, the investments are likely to be compelling.

And now a brief return to the most-referenced decade in investment markets to the current one, the 1930s. Barrie Wigmore, in ‘The Crash and its aftermath’ (Greenwood Press, 1985) shows the relative performance of industrial sectors following the 1929 collapse:

“Most of the heavy industries suffered disproportionately in 1930. Auto production dropped to 50% of capacity, and auto stocks dropped to 21% of their highest 1929 prices, compared with the average for all stocks of 36%. Several heavy industries which had satisfactory earnings in 1929 suddenly registered deficits or virtually break-even levels of earnings in 1930 and were revealed to have much greater economic problems than anticipated. Railroad, steel and tyre companies fell into that group, and their stock prices dropped to two-thirds of book value, compared with the average for all stocks of 139%. The heavy, commodities-based industries, such as the oil, mining, farm equipment, and pulp and paper industries, had similar profit and stock price performances, and the companies’ problems were exacerbated by sharp commodities prices declines and intense foreign competition with cheaper costs.

“The industries which emerged in 1930 with small profit declines, or even profit increases, were less capital intensive and oriented towards consumers rather than business, as in the food, consumer products and tobacco industries. These industries still had returns on equity of 20% or more, compared with the average of 11.6% and their stocks generally declined 50% or less from their highest 1929 prices. The chemical and operating public utility industries were not as profitable as these consumer-oriented industries, but were clearly stable, profitable industries whose stocks were undergoing a favourable reevaluation.”

Further historical reinforcement, in other words, of the defensive case for consumer staples, utilities, food and tobacco stocks. The reference to industrial company stocks in 1930 dropping to two thirds of book value is particularly interesting, given the number of stocks in the FTSE 350 now trading at tiny fractions of their book value. So again on a selective basis, equities have real appeal, both on explicit valuation grounds in an absolute sense, and relative to their traditional asset peers, bonds (particularly government bonds) and cash.

Intriguingly, a ranking of the FTSE 350 by Altman Z-Score shows that many of the highest-rated companies – i.e. those expected to weather the recession better than much of the market – sit within the energy and mining sectors. And as Diapason’s Chief Strategist Sean Corrigan recently wrote, with governments “taking the lead role in.. economic trench warfare, inefficiencies will abound.. and spending will be largely concentrated on goods, not assets and undertaken largely for its make-work possibilities..” which also implies that “the steep inflationary slopes which flank the far side of our present deep valley will be focused much more on things material and not on those financial, as was the case in the recent past. Commodities will not languish long at these depressed levels once this becomes more widely appreciated.”

The history of the 1930s is instructive. Commodity prices entered a bull market in the early 1930s on the back of inflationary policies pursued by the Roosevelt ‘New Deal’ administration. The boom came to an end in 1937 but was followed by even bigger stimulus. Commodities entered into a multi-year bull market, triggered in large part by the devaluation of the dollar.

Investors betting on deflation are betting against the historic success of western governments at fostering inflation. While the timing will inevitably be a matter for debate, hence Sean Corrigan’s reference to the “far side” of our present “deep valley”, deflationists are also underestimating the historic scale of the current intervention. Jim Bianco of Bianco Research recently tried to put just the US figures into context. He concluded that the extent of the US bailout to date is currently bigger than all of the following US government expenditures combined:

  • The Marshall Plan. Cost: $12.7 billion. Inflation-adjusted cost: $115.3 billion.
  • The Lousiana Purchase. Cost: $15 million. Inflation-adjusted cost: $217 billion.
  • Race to the moon. Cost: $36.4 billion. Inflation-adjusted cost: $237 billion.
  • Savings and Loan crisis. Cost: $153 billion. Inflation-adjusted cost: $256 billion.
  • Korean War. Cost: $54 billion. Inflation-adjusted cost: $454 billion.
  • The New Deal. Cost: $32 billion (est.). Inflation-adjusted cost: $500 billion (est.)
  • Invasion of Iraq. Cost: $551 billion. Inflation-adjusted cost: $597 billion.
  • Vietnam War. Cost: $111 billion. Inflation-adjusted cost: $698 billion.
  • NASA. Cost: $416.7 billion. Inflation-adjusted cost: $851.2 billion.

That aggregate total of $3.9 trillion is $686 billion less than the cost of the credit crisis in the US thus far. And as commentator Barry Ritholtz points out, the only event that comes close to the cost of the current financial crisis is World War II, with the inflation-adjusted cost borne by the United States summing to some $3.6 trillion. Bloomberg calculates that the US taxpayer is on the hook for a total of $7.76 trillion of liabilities, which equates to $24,000 for every man, woman and child in the country.

Some exposure to government and high quality corporate debt currently makes sense as an alternative to miserly deposit rates and as the logical response to depression / deflation fears. But as soon as we see evidence of general price acceleration – and that evidence admittedly may not come this year – it will then make even greater sense to have exposure to high quality equities, commodities and precious metals as classic inflation hedges. Asset diversification didn’t work in 2008 – a wholly extraordinary year for any number of reasons. That does not mean that it will fail investors in perpetuity.


Originally published at The Price of Everything and reproduced here with the author’s permission.