Hell’s Quarter

January 7, 2009

Dear Investor:

It’s difficult to sum up the events of the past quarter in one letter. It was the worst three months in financial markets since the dark days of the 1930′s. The fallout has been wide and deep. The global economy is now in severe recession, one which will last for at least half of 2009.

We underestimated the depth of the market declines and the economic damage, which caused us to overweight equities too early. Our belief was that equities were already cheap going into this mess–having had their pricing excesses wrung out of them during the grueling bear market of 2000-2002. I imagined that a 25% peak-to-trough decline was possible, but more than that was unlikely. This was wrong to the tune of double. The Dow declined nearly 48% from its high. Since we roundly anticipated the real estate collapse (and wrote about it for two years leading up to the bubble’s bursting), this blunder is all the more galling. Our view on housing caused us to avoid REIT’s, homebuilders and anything directly related to housing. But we bought shares in large, multinational financials, which we reasoned were diversified enough to withstand the pain. Some were, some weren’t; even the strong have suffered.

In the end, there was nowhere to hide anyway: retail stocks, commodity stocks, industrial stocks, consumer stocks, tech stocks, even healthcare stocks all collapsed. Debt markets collapsed, gutting munis and even high grade corporate bonds. Precious metals, oil, natural gas, real estate, all jumped off a cliff. Only treasury bonds and cash held value–and their pitiful yields offered negative real returns against inflation.

You’re probably less interested in the painful year past (and our mea culpas about it) than you are in 2009. Our view is the same as two months ago: that the intensive global fiscal/monetary stimulus underway–the most intense ever–will prevent this awful recession from turning into another Great Depression. History shows that depressions are rare events, caused not by booms and busts, but the lack of monetary stimulus in the wake of credit contraction. Right now, the stimulus is unprecedented in scope and size. Odds are it reflates the economy and creates a new set of imbalances (more on that later).

As we’ve said before, this question is crucial because another depression would warrant selling stocks here and now. A recession would render selling an awful mistake.

The difference in economic reality between a recession and a depression is vast, more so than most people realize. The old saw says that a recession is when your neighbor loses his job, a depression is when you do–showing all is relative. But in economic terms a severe recession doesn’t contract aggregate GDP more than 10-12%. Even pessimistic predictions for the current debacle are for no more than a 6% contraction. The Great Depression shrunk GDP by nearly 50%. The variance in this magnitude is enormous since each and every point of contraction in GDP represents huge economic misery. 6% vs. 50% is the difference between a rowboat and the Titanic.

We were right about one thing: that markets would begin to recover long before the economy. And that the markets would price in recovery while the real economic backdrop continued to get worse. The Dow has rebounded nearly 20% from the 7552 low of November 20, against a backdrop of grim news: layoffs, bankruptcies, frauds and flameouts. This is the typical pattern. Markets start to price in the healing process well before it ever begins, confounding those who sell at the bottom. From 1932 to 1937, the Dow quintupled from 41 to 194 (an increase of 373%) against a backdrop of bread lines and Hoovervilles. Even if the Dow revisits the 7500 level, it’s likely to then head higher in advance of even the first positive headline.

By definition, most people sell at the bottom. That’s what makes a bottom. Therefore, most shareholders sold during the terrifying week of November 20, 2008-whether they were forced to by margin calls or by good, old-fashioned panic. They now are bitten by the rally, since they don’t know whether to buy at these higher prices and risk another downturn–or wait longer. The choice, unknowable as it is since markets can’t be predicted in the short-term, becomes paralyzing and impossible. That’s why we believe timing markets is a mistake. Rebalancing from overvalued sectors to the undervalued makes a lot of sense, but trying to time the market by moving to cash–and then zigging back–is fraught with the potential for enormous mistakes. Research shows no one can do it well on a sustainable basis.

The investment approach–one which eschews short-term trading–can be painful since it entails waiting out difficult periods like the present. But the track records of most traders are spotty and poor, while the great creators of wealth like Buffett are long-term investors through and through.

A risk of the monetary stimulus underway is that money expansion will spark inflation. Hyperinflation is unlikely if central banks are vigilant, but inflation above the comfortable historical trendline of 3% is probable. Over the past few weeks, and in preparation for inflation, we’ve added an allocation to gold mining companies (via the Market Vectors gold exchange-traded fund, symbol GDX, a basket of precious metal stocks) in all accounts where appropriate. Normally, we don’t think much of gold as an investment. The bullion itself pays no interest, is impossible to peg in intrinsic value and has a 100-year annualized real return of approximately zero. We also tend to dislike gold miners, with their poor returns on invested capital, boom-bust cyclicality and lack of competitive advantage. But gold mining stocks are now very undervalued, in the wake of the commodity collapse of 2008. Gold stocks were down 35% over the past year as gold prices swooned in the deflationary scare of the fall. Given that we believe reflation will now lead to inflation, the investment case is compelling. Gold mining stocks are a less perfect hedge against inflation than the bullion since some of them in turn hedge gold prices. But they have the advantage of being valued on cash flows and paying an average dividend yield of 3%–something of great value as we face a potentially long wait for inflation to kick in.

We continue to be very bullish on the financials. The financials have outperformed the commodity, industrial and retail sectors since July and we think this will continue. The bulk of financial restructuring is well into the seventh inning and the attention of markets has turned to companies that have not yet faced the bulk of their future damage from the real economy. Though some have (and will) go bust, the bulk of strong financial companies will survive, prosper, seize market share and go on to be great investments.