"I do not claim that all market behavior is a rational response to changes in the real world. But most of it must be."
—Alan Greenspan, September 4, 1998
When we last wrote to you at the end of July, the Value Trust was up 23.33% through the first six months of this year, and the S&P 500 was up 17.71%. Since then, the stock market suffered its worst quarter of the decade as the S&P fell 9.95%, the Dow 11.97%, general equity funds 14.93%, and growth funds 13.44%. Your Fund performed better than general equity funds and better than the average growth fund, but still trailed the S&P, falling 11.64% in the quarter.
The obvious question is what changed since the end of July, and what do we make of it?
The post mortem on the quarter usually cites the crisis in Russia and its default on its debt as the precipitating event that shocked investors, raised their sensitivity to risk, and generated fears that the financial crisis that had been confined to Asia was spreading and may not be containable. Fed Chairman Greenspan gave credence to these concerns with his "oasis of prosperity" speech, noting that the US was unlikely to remain unaffected by the financial storms sweeping the globe.
In mid-September, government officials appeared to be preparing to attempt to contain the crisis before it reached Latin America. Treasury Secretary Rubin said it was vital to our national interests that countries such as Brazil (whose GDP is half the total in Latin America), which have followed International Monetary Fund prescriptions, not have their progress derailed by forces outside their control. The administration signaled it was developing a financial aid package to assist Brazil, reinforcing the determination to try to isolate the contagion outside this hemisphere. Then Long-Term Capital Management happened.
Long-Term Capital, as you may have read, is a large hedge fund run by an all-star cast that includes two Nobel prize-winning economists, a former Vice Chairman of the Fed, and several of the most accomplished traders in the financial community. As a result of substantial losses in the month of August, it had burned through most of its capital and needed additional equity or credit to prevent collapse. It was reported that its trading positions exceeded $100 billion, almost all of which were supported by debt. To put this in perspective, in the Latin debt crisis of the 1980s, Chase Manhattan Bank had total exposure to all of Latin America of $26 billion; an amount sufficient to induce fears of collapse among investors.
In an extraordinary series of events, the Fed persuaded Long-Term's major creditors to advance an additional $3.5 billion of credit in exchange for 90% ownership and effective oversight of the firm. Long-Term's principals earlier rejected an offer led by investor Warren Buffett that would have transferred the firm's assets to Buffett in exchange for under $300 million of equity and another $3 billion or so of credit, along with contributions from AIG and Goldman Sachs. The rescue was cobbled together quickly due to the collective fears of the creditors and the Fed that the collapse of Long-Term might have destabilized financial markets as billions of dollars of assets were liquidated under duress.
These events stunned and panicked the markets. The crisis that was going to be contained before it infected Brazil suddenly showed up in Greenwich. It was as if the Center for Disease Control was preparing to dispatch a team to Africa to contain the Ebola virus and the virus showed up in New York. Risk managers in banks and brokerage firms began asking clients for additional collateral as the fear of loss replaced the desire for profit. A small 25 basis point (1) decrease in short-term rates by the Fed was deemed insignificant by markets as investors engaged in a mad scramble for safety and liquidity.
The crescendo was reached on October 8th when the panic to dump stocks resulted in 920 new lows on the New York Stock Exchange. Yields on T-bills fell the next day over 20 basis points, a remarkable flight to quality. As is usually the case in financial markets, when investors en masse frantically desire a particular asset class, the opportunities typically lie elsewhere.
Just as markets failed to appreciate the effect of the Fed's raising rates a year and a half ago, we think they underestimate the impact of the modest easing already experienced. The genesis of the current crisis was that 25 basis point increase in interest rates, which occurred when inflation was 2.7%. By the end of 1997, inflation had fallen to 1.4%. Real interest rates thus rose by over 150 basis points in less than nine months. That increase in real rates in the world's reserve currency led to a shift in risk preference by investors that gathered momentum as the year progressed, culminating in the panic seen in the past 60 days.
Beginning shortly after the Fed raised rates last year, investors systematically began preferring quality and liquidity at the margin. (All important activity in complex adaptive systems begins at the margin.) They first sold Thai baht for dollars until the Thai government ran out of dollars and the currency peg blew apart. This situation was repeated in Korea with the won, in Malaysia with the ringgit, and so on. They not only sold emerging market currencies against the dollar, they also sold developed country currencies. They sold riskier small stocks in favor of safer big stocks. By this spring, they began to sell the bottom 450 stocks in the S&P 500 in favor of the top 50, whose performance accounted for all the index's gain. In April, investors began selling stocks for bonds, then as summer wore on, high-yield bonds for investment grade; then investment grade and mortgage-backed for Treasuries. In the final scramble in early October, long- and intermediate-term Treasuries were sold for T-bills.
It was in this frantic atmosphere that the Fed cut rates. As happened last year with the increase, no one thought it was significant. But at the locus of last year's crisis, Asia, things were beginning to improve. Korea and Thailand had the best-performing markets in the world in the third quarter. Both countries have begun to lower rates and their currencies are beginning to strengthen. Japan has begun to implement serious banking reform, and its currency is sharply higher against the dollar. Closer to home, our yield curve has begun to steepen, a sign of decreasing pressure at the margin on the economy. Fixed income spreads have begun to narrow. In the nascent recovery in stocks in the past week, small stocks have outperformed large ones. Risk preferences are beginning to shift again.
In every case, at the margin, investors are slowly demanding lower risk premia. We think this is evidence the crisis is abating and that the risks of investing in equities are now lower than they have been in some time. This is not the majority view.
Lost on those now searching for safety and liquidity is the signal given by Warren Buffett. The world's most successful investor, who turned his allowance money into $30 billion, and who has for years preached the virtues of safety and liquidity, decided in late September to opt for illiquidity and leverage by bidding for Long-Term Capital's portfolio. Buffett has built his fortune in part by aggressively investing in assets when their prices are depressed due to real but overly discounted problems. In the bear market of 1974, when inflation and interest rates were rising, the Middle East was in turmoil, and politics was convulsed by Watergate, he aggressively bought stocks at the lowest prices in a generation. Earlier this year, he made a foray into the silver market when most investors had given up on ever making money in precious metals.
We agree with Buffett that significant opportunity exists in capital markets as a result of investors' sudden rediscovery of risk. The best opportunities are probably where the devastation has been greatest: in convergence trades in fixed income markets (betting that spreads between various types of instruments such as emerging markets debt and Treasuries will narrow), and in equities in small- and mid-sized stocks, REITs, and financials. Although the opportunities are greatest in areas we are not able to invest in, the market's decline in the third quarter created plenty in our venue. We have used the sell-off to aggressively buy bank stocks, whose price declines far overshot their exposure to global problems, and also to add to a variety of our positions at more favorable prices.
We bought two new positions in the quarter: United HealthCare and Mirage Resorts. United is the leading independent HMO in the country, generates free cash, is repurchasing its stock, is down 50% from its high, and trades at 12x earnings. We believe fair value is at least 50% greater than the present stock price. Mirage is the leading gaming company whose flagship Bellagio property just opened in Las Vegas. The stock recently traded at multi-year lows, the result of the present market malaise and pessimism about the supply/demand situation in Las Vegas. We think the present price is well below the intrinsic value of the business.
Two positions were sold: RJR Nabisco and the long treasury bond. RJR's business economics remain under pressure, both from governments and from competitors. The sell-off gave us a chance to re-deploy that capital more effectively. The market bid the long Treasury to its highest price and lowest yield in history and we decided to do our small part in relieving the financial crisis by letting panicked investors have some of the safety they so desperately sought. We think we can find lots of stocks that will give us a return greater than 5% a year, which is what the long bond now promises.
We believe the worst is over in capital markets and that the present situation favors long-term value investing. The macroeconomic environment of low inflation, declining interest rates, and moderate growth is positive for equities. Federal Reserve policy is now engaged in preventing or short-circuiting a credit crunch, and Fed officials have made clear their willingness to further lower short-term interest rates to preserve the economic expansion. Stock prices have declined sharply and investors will need time to regain their confidence. We have put several hundred million dollars of cash reserves to work during this decline and hope to earn quite satisfactory returns on our investment.
As always, we appreciate your support and welcome your comments.
Bill Miller, CFA
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