The thoughts of others
Were light and fleeting,
Of lovers’ meeting
Or luck or fame.
Mine were of trouble,
And mine were steady,
So I was ready
When trouble came.
A.E. Housman
These words from the poet, A.E. Housman, strike a deep chord within us.As you are aware, we have been thinking of trouble for some time.During the first quarter of 2008 it became quite apparent that troubleis here. We believe that there is more trouble to come.
The root of the current problems lay in the loose monetary policies putin place earlier in the century by then Federal Reserve Chairman AlanGreenspan. He dropped interest rates far to low and kept them there farto long in response to a mild economic slowdown following the burstingof the internet bubble and the terrorist attacks. The result of theselow rates was to encourage excess borrowing in all areas of theeconomy. Most importantly consumers went on a borrowing binge; usingthe rising values of their homes as ATM machines. As the Wall StreetJournal writes: “
Homes became the collateral for trillions of dollars in householdborrowing. That depressed savings, inflated consumption, fueled rapidlending and loosened lending standards to households, businesses andspeculators.” 1
Like all bubbles, it too burst.
Burst real estate bubbles are very serious and difficult to containbecause they cause massive wealth destruction. Home values dropped inthe latter half of 2007 and have dropped a further ten per cent so farthis year. Some economists are predicting that housing prices couldfall a further ten per cent this year and an additional ten per cent in2009. The total decline in home values could total forty to fifty percent since their peak. Should these declines occur, twenty one millionof the fifty one million homeowners in the United Sates could findthemselves in a negative equity position. As a result, severalindicators are starting to show that consumers are starting to retrench:
- Consumer confidence is at the lowest level in twenty six years
- Consumer spending is declining
- Auto makers are reporting double digit sales declines
- The inventory of unsold homes is near all time highs
In response to what several observers have described as the worstcrisis in a generation the Federal Reserve and central banks around theworld have dropped rates quite sharply over the past several months.However, these efforts are being complicated by record energy pricesand soaring food costs. When it rains it pours!
In contrast to our cautious view, many market participants believe thatthe worst of the turmoil has passed. They argue that the aggressiveinterest rate cuts mentioned above, government bailouts of troubledfinancial institutions and increased fiscal stimulus will result in aresumption of growth in the latter half of this year. Equity investorsappear to share this view. The Dow Jones Industrial Average hasincreased by approximately eleven per cent since its low point in midMarch.
We strongly disagree with this view. In fact we strongly believe thatthere is more trouble to come. Historically, there has never been atime when real estate values have declined dramatically without seriouseconomic fallout. Historical precedence would suggest that:
- Consumer spending will continue to fall
- Unemployment will rise
- Corporate profits will decline
- Many financial institutions will continue to record large losses
In short we think that we are in the early stages of an economic slowdown and that a serious recession is in the offing.
As we discussed in our last newsletter (available atwww.patientcapital.com) equity valuations are still above long termaverages. These “extended” valuations against a backdrop ofdeteriorating economic fundamentals scream RISK to us. Trouble is herewith more to come.
But we at PCM are ready. We are entering these turbulent times withsubstantial cash balances. Our philosophy of purchasing high qualitycompanies at very attractive valuations has helped us to avoid troubleand put us in a position to capitalize on opportunities as they presentthemselves.
Indeed we have already begun to see opportunities. During the lastquarter our equity investments have increased from fifteen per cent ofthe portfolio to thirty per cent; an increase of one hundred per cent!These new investments are in industry leading companies purchased atsubstantial discounts to their intrinsic values. We believe that thepotential for substantial long term returns is quite high.
After patiently waiting for a long time circumstances may be coming ourway. We are excited because in the face of trouble we are steadfast andready!
Vito Maida
May 2008