Quarterly Commentary January 2009

2008 Annual Review

On Madoff

A few years ago, a relative asked me to manage his money.  I have a rule against managing family money, for obvious reasons, but this relative was rather insistent.   His current advisor was retiring, and intended to hand off his account to an advisor new to the business (someone who, incidentally, had been a Big-O Tire salesman a year earlier).

I directed my relative to my website, and suggested that he read past Commentaries, so that he could make sure he was comfortable with my style and approach to the markets.  He felt that was unnecessary, since he was sure I would do a great job, and besides, the whole point of an advisor was never having to think about such stuff.  I explained that a little discussion now would head off potential misunderstandings in the future, and that I would not accept his account until he at least read a few of my Commentaries.

He wouldn’t do it.  He subsequently went with the tire salesman.

Lest my relative appear foolish (a fact I’m not arguing against, either), this nature of interaction is not uncommon.  In the nine years I have run money professionally, in an industry overrun with consultants, experts and armchair quarterbacks, I’m not sure I have ever met a sophisticated investor, even among other professional managers.  Since I assume every adult approaches life with some degree of wariness, it is fascinating that Madoff targeted the financially sophisticated – advisors, hedge funds, and institutions.  It is said that fear and greed (and I might add, laziness) are stronger than long-term resolve, and it is almost reassuring that human nature never changes.  If I were a lesser man, I might be smirking right now.

Of course, now the pendulum has swung hard, and I’m reading articles on how you can’t trust anyone.  Resume isn’t enough.  Experience and references are not enough.  Bill Miller, a legendary manager, had his first losing year.  His prior eighteen years of outperformance is now dismissed as just a lucky streak.

This is pretty dumb as well.  The biggest (financial) losers I know are people who never trust anyone, who see a con at every turn.  Ultimately, life must be lived in good faith, that the rules will ultimately apply. 

But the question remains:  how did Madoff get away with it?  By giving the customers what they want.  And on a certain level, it was a brilliant bit of marketing.

The hardest part of managing other people’s money is often… those other people.  Investment returns are, by their nature, lumpy.  They do not come regularly, and safely, like interest payments from a bank account.  But it is axiomatic that most clients are long-term investors – as long as they make money every quarter.  In a bull market, there are comments that an index fund would have been just as good, and a lot cheaper; in a bear market, well, the manager should have been more conservative.  And it is not only the smaller investor; the larger sophisticated investor is often worse.  Consultants evaluate money managers on both returns and volatility:  smooth returns are good; volatile (real world) returns are bad.  Hedge funds generally report every month; however, some clients expect weekly updates, and Jim Cramer wrote that he once had investors calling several times a day.

This is why many successful investment partnerships and hedge funds do not accept outside money.  They can no longer bear the headaches.

But if a money manager is looking for outside money, we in the industry all know that a track record of smooth, consistent returns will bring clients beating down the door.  In fact, it has been expressly stated that the holy grail of performance is a steady one percent per month – which is exactly what Madoff delivered.  The clients knew better, without a doubt.  But they preferred to believe the lie.

The case does bring forth two useful points worth noting:

1. Many of the Madoff investors had no idea they were Madoff investors.  That’s because their money managers are not money managers.  They are salesman on commission, who charge a fee simply to place the money entirely with someone else.  In fact, the majority of money managers are actually just middlemen (the industry term is “asset gathers”).  This is not necessarily wrong, or bad.  But many “advisors” are vague in this disclosure, lest they lose stature in the eyes of their clients.  There are double fees, and you may not know exactly where your money is.
2. Custodians versus advisers.  This one really stumps me.  Any legitimate adviser uses a third-party fiduciary.  For example, I use T.D. Ameritrade.  I can make trades, and request withdrawal of my fee every quarter.  Otherwise, I cannot touch the money.  A client wishing a withdrawal must contact Ameritrade directly.  Ameritrade issues its own quarterly statements.  It protects the client and the adviser.  Any other arrangement, by definition, screams of potential fraud.  It just isn’t done.

Fourth Quarter Review

Every quarter, before I write this section, I review my comments from the prior Commentary.  It does seem my anticipation that the worst had passed in the third quarter was a bit premature.

The fourth quarter was simply uninvestable, falling 25% in the first two weeks alone.  Virtually all equity markets essentially crashed in mid-October, and were wildly turbulent through the end of the year.  Many of the most volatile days in the history of the markets occurred in the last ten weeks.  Other than cash, or selling the market short, every investment strategy failed.  The Yale and Harvard endowments were down by 25-40%.  Hedge fund managers with decades of brilliant performance lost 50% or more.

By far, the best position was to be in cash.  But if any investor had not sold prior to the sell-off, the only rational act was to sit tight and ride the storm.  Volatility is a double-edged storm, and the propensity to get whipsawed was just too great.  At the beginning of the quarter, I concentrated our positions in a handful of fundamentally sound investments, paying high dividends.  Other than some tax selling for taxable accounts, I did not attempt to speculate or rebalance.  I believe it was the right, indeed the only, thing to do.

Hits and Misses for 2008

Hits: I ran a very conservative portfolio for the first seven months of the year, and performed well relative to the indices.  Much of this time, I ran a very high cash balance.

Misses: I reinvested in August and September – and went over the cliff with everyone else.

An unenviable feature of managing money is that the perfect course of action is always obvious – in hindsight.  Believe me, as I review the past quarter, the capacity for self-flagellation is bottomless.  An arms-length perspective helps separate the acceptable and inevitable features of the investment process from those areas that could improve with a review of tactics.

A money manager is primarily an asset allocator, concentrating investments in a secular upswing, and avoiding those areas in decline.  And because markets never move in a straight line, a surprising degree of volatility should be tolerated.  Many times I have been frightened out of a stock, only to then watch it double or triple in price without me.  Real money is made by sitting tight.

The sectors in which I have concentrated our investments, such as emerging markets, oil, and commodities, have a history of occasionally correcting hard in the course of a bull market.  For example, in the current cycle, this is oil’s fourth hard correction.  So much of what is occurring is in fact normal and anticipated.

Statistically, it is very hard to avoid damage in a market crash, even an anticipated one.  Diversification is useless in such situations, and timing a complete exit is exceedingly difficult.  Any regrets I may have over the last four-five months center on the following:

1. I did not fully appreciate the extent of the credit crisis.  Markets are marvelously self-correcting and forward-looking, particularly large, liquid markets like our bond markets.  The sub-prime crisis first struck in August, 2007.  The markets had over a year to digest and discount these problems.  That the issue would persist and strike again so forcefully a year later was a surprise.
2. Frankly, I was looking for rising interest rates as the “tell” to a more significant problem.  That interest rates did not rise in the face of rising defaults, and in fact continued to fall, is puzzling. 
3. Like many advisors, my circuit breaker system failed to pull me out of, or at least mitigate the damage of, a market meltdown.  I certainly have a new perspective on risk management.

A New Year:  Perspective for the First Quarter

There is a new wildcard in the deck:  the blatant manipulation of our markets.   Not by Wall Street, or third-world dictators, but by our own government, and matched by other central banks around the world.  Even with Japan’s lost decades as a clarion example, our politicians cannot help but “fix things” for momentary popularity.   And unfortunately, actions over the past year suggest that 1) our politicians have no idea what they are doing, and 2) they are nonetheless prepared to act in an extremely heavy-handed and slow-footed manner.

Government (or any “cartel”) cannot prop up or hold down asset prices.  Their actions have and will only impede the normal auction process.  They cannot make things better; they can only make it worse.  The markets will become more volatile.  The massive unleash of liquidity will either create high inflation, or a prolonged recession.

There is a coming tidal wave of money, from almost every solvent country and their central banks.  Emerging countries strive to prop up oil and commodity prices, developed countries strive to avoid depression.  All that bailout money has to show up somewhere.  It should certainly thaw the liquidity crisis – depending on the terms of the bailouts.  It cannot save real estate or reignite consumer spending.  There will be material unintended consequences.  I’m just not sure where, and when.

I had time over the holidays to read a few books on the history of markets, particularly during the Great Depression.  The history of manias suggests that when an asset bubble bursts, prices eventually return almost where they first started.  As such, investor complacency is deadly.  Fortunes were lost as investors waited until the market returned to “normal.”  Market volatility during the Depression translated into great bull runs in certain years.  John Maynard Keynes, the noted economist, made a fortune in the stock market during the 1920’s, lost it all in the crash of 1929, and then made it all back by 1935.  

Tactics

Bear markets have three stages – a sharp downturn, a reflexive rebound, and then a drawn-out fundamental downtrend.   Even though it is far too anticipated, a significant bear market rally is reasonable to expect in the first six months, given the 1) extreme selling of the last four months; 2) the anticipation of a new Administration; and 3) the anticipation of all that bailout money.

As such, I am pretty much right where I want to be as the New Year starts.  And indeed, the first few days of the trading year look pretty darn good.

Bonds and other fixed income:  Everything, EVERYTHING, points to higher interest rates.  The devaluing dollar.  Mounting defaults.  Enormous bond supply and waning demand.  A stimulus plan that almost guarantees a future inflationary crisis.  But these conditions have been in place for a while now.  And yet Treasury rates contradict every fundamental argument by continuing to fall.  Perhaps it is just a temporary manipulation by our Treasury, or a momentary, extreme flight to safety.

Or perhaps the bond market is forecasting a depression.

Shorting the long-term Treasury is the most discussed trade in the business – which makes it innately suspicious.  With extremely low interest rates and rising defaults, the risk/return characteristics of every category of bonds are ridiculous.  At best, it is dead money.  At worst, it is by far the riskiest asset class.  

I have read that many hedge fund managers are focused on distressed debt.  These men are smarter than me.  I can find no argument or justification to take any position in any kind of fixed income at the moment.

Municipal bonds.  Many investors are fleeing to municipal bonds, attracted by the high yields and history of low defaults.  However, as an investment banker, I am fully aware of the financial insanity committed by our state and local governments.  But it does not require a ringside seat.  Just two years after the end of the real estate boom, after all that property tax revenue, cities are declaring bankruptcy.  Schools and hospitals are forced to unwind interest rate swaps at ruinous expense.  Every municipality is begging the Obama administration for bailout money.

I would not be so sure about that low default rate.

Banks and other financial stocks:  It is logical that any kind of economic recovery must be predicated upon a significant thaw in the liquidity crisis – which suggests that financial stocks must be among the first to rise.  It makes sense – I’m just not sure I believe it.  There may be an interim bounce.  But every bank and Wall Street firm still has enormous commercial real estate assets on the books.  As retail and office building defaults begin to rise, it could easily swamp the banks’ fragile recovery.  The sector bears watching, but I am unconvinced that it is a sure play.

Oil has a history of volatility, so the rollercoaster ride is not unusual.  If you believe the emerging markets story, you must believe the oil story.  Growing demand exceeds existing supply.  And with the recent collapse in oil prices, all forms of exploration and alternative fuels have come to a halt.  Oil is also largely controlled by third-world dictators in unstable countries.  Oil remains a core position.

Commodities are still the best story in the market.  They were hit the hardest in the downturn, with many stocks selling for less than the company has in cash per share.  All exploration has ceased since the recent price drop, due to either company unwillingness to expand, or total lack of financing.  Commodities are a supply story.  The world economies do not have to reignite for commodities to do well.

Real estate is the only asset class in which the 1031 exchange rules apply.  As such, there is a tremendous tax incentive to roll one real estate sale into another.  Real estate runs in long cycles.  The residential market appears to be years from a bottom, particularly since prices are so weak in the face of such low mortgage rates.  While I think the “new” frugal consumer is as likely as the fat lady on an 800 calorie diet, I have no sense of the fallout from this asset crash.

In the commercial arena, a tenant-in-common investment (TIC) from a national sponsor is preferable to a REIT, in that the TIC has few moving parts:  the investor knows beforehand who the tenant(s) is, the lease terms, financing maturity, etc.  In this manner, it is possible to quantify the risk, rather than rely solely on the skill of a pool operator.

Global markets.   Europe may be the only other market in worse shape than the United States.  There is an argument that our weak dollar is being propped up by an even weaker euro.  Asia and the BRICs have the strongest odds of emerging early from the recession.  China in particular has a much larger stimulus package in progress, with the ability to institute much greater interest rate cuts.  I am watching companies and ETFs in Brazil and Chile in South America, and China, Taiwan, and Singapore in Asia.  Australia tends to reflect a pure commodities play, so I believe I’m covered by other investments.