Friday, July 07, 2006

2006 Quarter 2 Update

July 7, 2006

There may be differing opinions as to the cause of the decline in equity prices throughout May and June of this year; however there is little argument as to the severity of the decline itself. For some perspective on this move in equity prices we offer the following:

As of May 10, 2006, the Dow Jones Industrial Average was 100 points away from a record high. Three volatile weeks later, the DJIA stood more than 4% lower than its May 10 level while the MSCI Emerging Markets Index dropped by 15%, led by declines in all major developing nations, including an 18.5% drop for Brazil, Russia, India, and China.

And what of the myriad of reasons given for the sell-off? Many believe that inflation is the real culprit, hence the increasingly hawkish statements made by the heads of the Federal Reserve, namely Ben Bernanke. While this belief likely has some validity to it, consider the fact that on an historical basis, headline CPI readings are generally inline with the average since 1980, with the core reading even more subdued as it remains near all time lows. Of course these numbers tend to be historical in nature so we might be in for higher ones in the coming months. That being said, we have just witnessed nothing short of a complete “smackdown” in commodity prices, a good thing when it comes to future inflation readings and the concerns surrounding them. So perhaps much of the work has been done with regards to inflation going forward, albeit an extremely painful process to endure.

Others believe that one of the major causes of this equity decline stems from a lack of confidence in the new Federal Reserve body. It is true that the retirement of Alan Greenspan ushered out an era of confidence in the Federal Reserve based on a solid track record going back to the mid-1980’s. Whether one was a fan of Greenspan or not, he no doubt had the ability to comfort market participants in times of uncertainty and fear. This, however, is unlikely to have resulted in such a severe market correction in the domestic and global markets alike.

No, the real culprit in the May/June market meltdown was years in the making and weeks in the undoing: Liquidity. Hard to believe that so much pain and confusion can be summed up in one simple word, isn’t it? But we believe that it can. As Mark Gilbert at Bloomberg states so eloquently, “The Federal Reserve has taken away the punchbowl it spent two years pouring absinthe into.” This, we believe, is the true culprit.

As more and more liquidity was added to the system via Federal Reserve short term rate cuts (ultimately ending at a mere 1% following the recession in the early part of this decade) there was put into place a process of “mispricing risk.” With so much available cash sloshing around the system investors were encouraged to take on more risk (or perhaps unable to resist) than they might otherwise have taken under a different scenario. When this excess cash is soaked up via interest rate hikes there begins a process of “repricing risk.” This process involves deleveraging, and deleveraging can be brutal and indiscriminate as we have recently witnessed (and therein lies the good news which we will touch on shortly). Investors are bound to price risk differently when the Fed funds rate is 5% and rising rather than 1% and flat. And it’s not just the U.S. Federal Reserve that has removed the punchbowl. Europe and Asia have been acting in kind which has only exacerbated the problem for the global markets.

So how is any of the above information positive for domestic financial markets going forward? Believe it or not there are many reasons to view this “repricing of risk” positively over the longer term. As discussed above, rather than ignoring the elephant in the room we have finally addressed the possibility of an inflationary environment going forward and taken steps to avert this reality. No one can know for certain whether or not we will succeed in containing inflation, but by taking proactive steps now we certainly increase our chances tremendously. The meltdown in commodities and the removal of excess liquidity by the Fed should go a long way in doing that.

Any time asset prices are adjusted downward there is the opportunity not only to pick up assets at better prices but to find assets that are most certainly “mispriced.” In their efforts to deleverage and raise cash at all costs market participants are likely to have thrown many babies out with the bathwater so to speak. While this can be painful to watch for fundamental investors who hold assets that they believe to be in the above cohort, it can also provide phenomenal opportunities for those willing to do the legwork to find such situations. This is exactly what we intend to do as the dust finally settles.

As investment managers it is important for us to remember that fight or flight is a fabulous mechanism when being chased down by a lion, but not all that great for quelling an emotional response to a stock market beating. We will be looking through the rubble of this global meltdown in the hopes that we can find some jewels worth owning at this stage. What we’re really referring to here is what Michael Mauboussin aptly names “time arbitrage”:

Asset prices reflect a set of expectations. If investors chasing noise create a set of expectations inconsistent with the long-term signal, an opportunity for time arbitrage arises. This arbitrage works only if the short-term focus creates a diversity breakdown-too few investors focused on the signal-and the signal becomes clear over time. So the critical considerations in navigating the investing world distill to psychology, incentives, and expectations. Intelligent investors remain highly aware of all three, and use them for the advantage of their fund holders.

Put simply, as investors have become more and more short-term oriented market corrections such as this have become important buying opportunities for those with a longer-term horizon. Of course this does not mean that just because a stock is down it is automatically a bargain. There will be plenty of companies, and therefore stocks, that will continue to suffer due to exposure to the wrong parts of the economy as we enter a new cycle. However in the process of weeding out the aforementioned companies there will be plenty that are cast aside unnecessarily, either as a result of association or the need to raise cash quickly. These are where value can be found.

As always, we appreciate the confidence and trust you have shown in us by hiring our firm as your investment manager and we look forward to a great second half of 2006.


Paul R. Ray III Brian M. Phillips