Praise for the Commentariat

The global financial crisis is throwing up some wonderful material from what I like to call the market commentariat - those whose job is to pronounce on the market's movements and advise on what investors should do about it. We are living through a quite remarkable period in financial history, and it is good to see that some commentators are up to the enormity of the issues involved.

Here are three examples that have caught my eye in the last few days.

First up is Don Coxe, now thankfully back in action after a short interregnum with his monthly commentary Basic Points (always required reading). He quotes Robert Reich, Clinton’s Labour Secretary, "one of the nation’s smartest liberals", who described President Obama's stimulus plan with characteristic clarity: “Obama has repealed the Reagan Revolution”. And then added this tart comment: "Problem: the Reagan Revolution was the best thing that has happened to equity investors since World War II”.

"The long Reagan boom that came after the last Mama Bear market so energised the markets and the economy that the S&P trebled in five years, and laid the foundations for 900% returns over fifteen years. We shall not see its like again. The entrepreneurial spirit that Reagan praised and unleashed with tax cuts and deregulation is now the object of Obama's obloquy and Obama's program of huge tax boosts, denial of secret ballots in union organisational efforts and massive costs to fight global warming argue for, not a Thatcherite, but at best a Belgian economic recovery".

Don's current investment conclusions can be summed up like this:

• Gold as a core holding;
• Canadian and Australian dollars for choice amongst currencies;
• Fertiliser, seed and farm equipment stocks by mid-year (watch out for the continuing absence of sunspots, a key Coxe theory to justify investing in grains);
• The debt of good companies rather than the equity (at least for now).

"A wondrous buying opportunity" may emerge in stocks if the S&P 500 index breaks down heavily again, which he seems to think is the most likely outcome.

Someone also passed on to me this concise summary, from the same side of the political spectrum, of comments made by the veteran natural resources investor Doug Casey at a recent conference:

"The US is going to default on its debt through inflation. Obama has a really high IQ but is unable to foresee the consequences of his actions. 9 trillion dollars deficit divided by 300 million, that's about $30,000 per person and all that money is directed to the State. Government is the Predator and you are the Prey. Yes, I pay taxes in this country but it is for the same reason that I give my wallet to the average mugger at gunpoint".

Finally I also enjoyed an excoriating attack on Gordon Brown in The Times of London by Matthew Parris, a onetime centrist Tory MP turned pundit. It is impossible to underestimate the extent of the mess to which policymakers and bankers in harness have brought the UK. George Soros says it is possible we may end up in the arms of the IMF once more, as we did in 1976. Exaggerated? Perhaps -but not, I fear, impossible.
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Sentiment Can Change So Fast

My apologies for the recent break in transmission, the result of travel and other commitments. The way the equity markets have rallied since the beginning of March, perhaps I should stay away for longer! This is the full text of my latest FT column. It seems a safe bet that we will now see a new wave of bullishness from commentators, arguing (with Anthony Bolton and in today's FT, reasonably persuasively, Tim Bond of Barclays Capital) that the bear market has now bottomed out. I am not prepared to go that far, as the risk of more pain remains significant, but the recent recovery in financial stocks, a necessary pecursor to any new bull market, is certainly encouraging. Sentiment can change very quickly in this game.

Contrition, whether real or simulated, appears to be the new watchword in financial markets, if not in political circles. In the spirit of the times, my confession is to own up to having taken a certain amount of guilty pleasure from reading Cityboy, a coarse and unpleasant book about the workings of the City of London, published last year. By all accounts this terribly written piece of tosh, billed as revealing the “explosive secrets about life in the devious, murky and often corrupt heart” of the Square Mile continues to sell very well.

The reasons are not, in truth, hard to find. Public anger over the attitudes and behaviour of bankers is being whipped up by the media and politicians desperate to divert blame anywhere but onto themselves. Professionals who once thrived on the back of the explosive growth of investment banking, derivatives and hedge funds are suddenly facing lean times. Many banks, City law firms and accountancy practices, one hears, are cutting back on graduate recruitment and some have been forced to move, unprecedentedly, to part-time working.

With unemployment rising and the recession deepening, it is no surprise that popular sentiment about the City should be turning so hostile. Books such as Cityboy are both symptomatic of the trend and responsible for its wider propagation. The reason they sell well is that there is a sufficient amount of truth in the picture they paint of how the financial markets function to confirm the most painful prejudices, just as Caryl Churchill’s memorable play Serious Money did for the Yuppie generation twenty years ago.

Some of the recent histories of investment banks, such as William Cohan’s riveting history of Lazard Freres, or Philip Augar’s excellent series of studies of the modern Square Mile, of which Chasing Alpha is the latest, have painfully exposed how the dysfunctional management processes and ego-driven internal feuding that often characterises such institutions typically results in most of the economic rents obtained by investment bankers accruing to the employees while the owners continue to bear the risks and eventual losses. They are the High Priests of the “return-free risk” that victims of the sub-prime crisis, investors with Madoff and others have discovered they were really being sold.

Geraint Anderson, the author of Cityboy, gives his slant on the same phenomenon by caricaturing what he sees as the unhealthy motivation of research analysts, hedge fund managers and other investment professionals. His fictionalised account of the cynical advice he was given on how to get on as an equity analyst is, however, painfully close to that I recall being given myself when I was offered an analyst’s job by a well-known stockbroking firm shortly after Big Bang.

“The moment you take this job seriously”, runs Point Number Six in his litany of must haves in the analyst’s life, “the moment you give a shit that a share-price movement goes against your recommendation or that a client doesn’t like you, you’re done for. Never forget this job is just about money-grabbing dickheads pointlessly pushing around bits of paper. It ain’t curing cancer – it’s just the best legal means of making vast amounts of cash as quickly as possible”.

In the case of the firm that approached me all those years ago, it was made very clear that more time would be spent drinking with and schmoozing fund managers than engaging in fundamental research of any kind. It was better, so the advice went, to be precisely wrong than roughly right.
At all costs keep the client happy, whatever it takes. And so on. Has the game changed much since then? The answer of course is both yes and no.

The City has always been capable of reinventing itself with astonishing regularity, and will surely do so again. With hindsight, the speed with which the investment banks in the US were able to shrug off the findings of the Spitzer enquiry, for example, was breathtaking. My prediction is that current public hostility to banking excess and indefensible greed will also pass more quickly than many imagine possible.

Some things remain constant. The requirements for successful investment, as opposed to winning the game of short term performance, remain much the same now as they have always been: an enquiring mind, an ability to think for oneself and if necessary act alone, an understanding of the meaning of fiduciary responsibility and a degree of humility in the face of the market’s unchanging capacity to surprise and confound the views of even the smartest participants.

In the last few days, which have seen the S&P 500 index rally by 16% in six trading days, the old witch is clearly playing its tricks again. “Is this rally the real thing? Have we really reached bottom?” asks Albert Edwards, the splendidly bearish strategist at Societe Generale, one of several who meets the criteria mentioned above. He adds: “It would be wrong to say I do not agonise that I might not be missing a turn. I’m riddled with self-doubt”.

So are we all. Although rarely a saleable commodity in equity markets, doubt is the permanent condition of the true market prognosticator. My prediction remains that we will get a big market rally this year, too big to risk missing out on, but that the odds on equities breaking through their recent lows nevertheless remain worryingly high. Gold continues to look an attractive two-way bet, even though so many now profess to think so.
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Catching The Falling Knife

Below is the original version of my latest FT column. Equity markets are as oversold as they have ever been, and the selling momentum has been relentless. There will surely be some sort of rally soon, but it is not one that I am yet ready to trust as marking the end of the bear market.

The metaphor that originally seemed to capture the global financial crisis best was Jeremy Grantham’s “slow motion train crash”, in which a world dominated by unsound monetary policies and reckless bankers headed inevitably towards its eventual demise, unable or unwilling to abandon the course that had led them to this point in the first place. (Some, like the UK Prime Minster Gordon Brown, appear to be still in denial that they were ever driving the train).

However the market action of the first two months of 2009 brings to mind another metaphor, that of the “falling knife” that only the foolhardy will be trying to catch. The speed with which the markets have taken out the lows of November 2008 and headed further south in the last two weeks has been as breathtaking as it has been brutal. For the Dow Jones index to lose 20% of its value in two months is some going.

Clearly, when such powerful market momentum develops, there are dangers in trying to stand in the way. There is no obvious reason why the markets cannot now go on to test further new lows. Valuations, though beginning to look attractive on a medium term view, are not yet anywhere near the level – dividend yields as high as 10%, p/es as low of six - which typically characterise the bottom of history’s worst bear markets.

In a world where the average institutional holding period for equities has fallen to an absurdly low nine months, and relative performance and career risk drive the behaviour of many investment institutions, such downward dynamics could become as lethally self-feeding as portfolio insurance was in 1987. Investors’ emotions are already being tested further by the exceptionally high levels of daily volatility, and if sentiment continues to buckle, the Dow at 5000 or even lower is by no means an impossibility.

By its nature, however, this is the kind of market in which value gets trampled by momentum, and by extension therefore a period in which fantastic returns will be made and lost by those with the liquidity and nerve to identify the worst cases of mispricing. It is also the mechanism by which future generations who have been effectively excluded from the housing and equity markets by overvaluation will eventually be priced back into their normal long term real returns.

As usual Warren Buffett almost certainly has it right when he says that the markets have moved from underpricing to overpricing risk. In his latest Annual Report he confesses to Berkshire Hathaway’s worst annual performance since he first took control more than 44 years ago (this is based, it has to be said, on his chosen performance measure of book value per share, which would not be everyone’s choice, as its effect is to smooth out some of the volatility produced by year-on-year marking to market ).

“In 75% of those [44] years” he writes “the S&P stocks recorded a gain. I would guess that a roughly similar percentage of years will be positive in the next 44. But neither Charlie Munger, my partner in running Berkshire, nor I can predict the winning and losing years in advance. (In our usual opinionated view, we don’t think anyone else can either.) We’re certain, for example, that the economy will be in shambles throughout 2009 – and, for that matter, probably well beyond – but that conclusion does not tell us whether the stock market will rise or fall”.

Those who criticise Buffett for his bad timing, as many invariably do in a falling market, take comfort from the fact that the market has fallen since he first started making his comments about equities, inferring (to their own satisfaction, at least) that this makes them smarter than him and that he must therefore have been wrong. All it actually shows however is that their investment horizons are much shorter and that their investment philosophies are radically different.

If he were of the bragging kind, Buffett could easily respond by pointing to his 20% per annum compound return over 40 years, his place at the top of the Fortune list of wealthiest individuals, his high-yielding investments in Goldman Sachs, Wrigley et al, and ask: “where’s your equivalent”? In fact, one of the reasons Buffett has always stood out from the investment herd is precisely because he is often happy to own up to his share of real howlers. What could he have been thinking, for example, when buying Irish bank shares in 2008 and Conoco Phillips when the oil price was above $100 a barrel? It is a useful reminder that even great stockpickers can behave like idiots at times.

Is Buffett right to say that inflation is now the greater risk? It certainly looks that way to this observer. Is he right to say that the U.S. Treasury bond bubble of late 2008 may be regarded by future historians as “almost equally extraordinary” as the Internet bubble and the US housing market bubble? Again, yes. The major difference between the equity markets now and 18 months ago is that further falls from here have a good chance of being reversed relatively quickly, which was not a case that could be made before.
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Adrian Frost: Are UK Dividends Secure?

No question is more topical today than how sutainable the dividend yield on the market might be. If there is a case for holding equities, it rests on the impressive-looking yields that are currently available on a number of well-financed UK companies. These are the views of Adrian Frost, the highly regarded income fund manager at Artemis, as reported on the Hargreaves Lansdown website. (In the interests of full disclosure: I am a non-executive director and client of Hargreaves Lansdown).

"One thing is sure. 2009 will see more dividend cuts. We saw just short of 100 such cuts in the FTSE All-Share in 2008. More will follow. For the moment they are confined to banks and economically sensitive areas - but this may spread. Yet at the moment, despite the FTSE All-Share Index indicating a dividend for 2009 some 7% below last year (source:DKB), we believe that the dividend on prudent equity income funds will be flat at worst".

"Looking ahead, the 'big question' is: are (enough) dividends sustainable? Consider five salient facts:

• 37% of all dividends are paid in US$. So unless you think the dollar will die, these seem okay.
  
• 25% of UK dividends come from oil companies. To us, BP, Shell and so on look cash-rich and healthy, and say that they could maintain dividends for a year even at $35/barrel.
  
• The top 25 London-listed companies generate 74% of UK dividends.
  
• The top eight companies - HSBC, BP, Shell, Vodafone, Glaxo, Astra, BAT and BT - generate 50% of UK dividends. We own them all, except (for very good reasons, in our view) BT.
• "Four years ago, 43% of our fund was in FTSE 100 companies. That percentage is now 76%.
  

"Our fund's yield is 6%*. Do we think that, without undue risk, we can maintain that? Yes. Our view is to hasten slowly in the months ahead. Stick to the basics, cash flow and dividend, and all should be (relatively) well".

My comment: nobody can doubt that the first two months of the year have been brutal for the equity markets, but dividends are the key to long term equity returns. The recent LBS/Credit Suisse Global Investment Returns Yearbook showed that at the end of 2008 the long run capital return on equities since its authors's data series began (in 1900) was less than half of one per cent, with all the return coming from reinvested dividends.

A 6% market yield, if it does indeed prove to be sustainable, has historically never failed to produce strong equity returns over five years - something to cling on to as the value of your equity portfolio is slashed further by the current wave of violent downward lurches in the leading indices.
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Warren Buffett's Mea Culpa

Here is an extract from Warren Buffett's latest Annual Report, in which he admits to a number of mistakes during 2008. One measure of how serious the current crisis has become is that last year Berkshire Hathaway, Buffett's holding company, had its worst year's performance since it began life in the late-1960s, with its book value per share falling 9.5% (against the S&P 500's 37% decline). Shares in Berkshire have taken an even bigger hammering, falling 30% or so.

As someone who has followed this great investor's doings for 18 years, my advice is simple: beware of those who try to write him off as over the hill, or out of touch, or any similar comments. it is true that Buffett is no longer a young man - he is approaching 80 - but bear in mind two things. One is that he is virtually alone among profesional investors in admitting to mistakes of any kind. Such honesty is a refreshing contrast to the self-serving excuses that you will find in the average fund manager's report to the fundholders.

The second is that his rare errors of judgment - of which buying shares in two Irish banks last year must surely rank as one of the most extraordinary - are invariably more than cancelled out by successes on the other side of the equation. His self-disparaging remarks have always to be seen in the context of his extraordinarily succesful long term track record. The earnings performance of Berkshire's operating businesses last year was remarkably good in the context of the year's deteriorating economic backcloth.

"I told you in an earlier part of this report that last year I made a major mistake of commission (and maybe more; this one sticks out). Without urging from Charlie or anyone else, I bought a large amount of ConocoPhillips stock when oil and gas prices were near their peak. I in no way anticipated the dramatic fall in energy prices that occurred in the last half of the year. I still believe the odds are good that oil sells far higher in the future than the current $40-$50 price. But so far I have been dead wrong. Even if prices should rise, moreover, the terrible timing of my purchase has cost Berkshire several billion dollars".

"I made some other already-recognizable errors as well. They were smaller, but unfortunately not that small. During 2008, I spent $244 million for shares of two Irish banks that appeared cheap to me. At yearend we wrote these holdings down to market: $27 million, for an 89% loss. Since then, the two stocks have declined even further. The tennis crowd would call my mistakes “unforced errors.”

"On the plus side last year, we made purchases totaling $14.5 billion in fixed-income securities issued by Wrigley, Goldman Sachs and General Electric. We very much like these commitments, which carry high current yields that, in themselves, make the investments more than satisfactory. But in each of these three purchases, we also acquired a substantial equity participation as a bonus. To fund these large purchases, I had to sell portions of some holdings that I would have preferred to keep (primarily Johnson & Johnson, Procter & Gamble and ConocoPhillips)".

"However, I have pledged – to you, the rating agencies and myself – to always run Berkshire with more than ample cash. We never want to count on the kindness of strangers in order to meet tomorrow’s obligations. When forced to choose, I will not trade even a night’s sleep for the chance of extra profits".

"The investment world has gone from underpricing risk to overpricing it. This change has not been minor; the pendulum has covered an extraordinary arc. A few years ago, it would have seemed unthinkable that yields like today’s could have been obtained on good-grade municipal or corporate bonds even while risk-free governments offered near-zero returns on short-term bonds and no better than a pittance on long-terms. When the financial history of this decade is written, it will surely speak of the Internet bubble of the late 1990s and the housing bubble of the early 2000s. But the U.S. Treasury bond bubble of late 2008 may be regarded as almost equally extraordinary".

"Clinging to cash equivalents or long-term government bonds at present yields is almost certainly a terrible policy if continued for long. Holders of these instruments, of course, have felt increasingly comfortable – in fact, almost smug – in following this policy as financial turmoil has mounted. They regard their judgment confirmed when they hear commentators proclaim “cash is king,” even though that wonderful cash is earning close to nothing and will surely find its purchasing power eroded over time".

"Approval, though, is not the goal of investing. In fact, approval is often counter-productive because it sedates the brain and makes it less receptive to new facts or a re-examination of conclusions formed earlier. Beware the investment activity that produces applause; the great moves are usually greeted by yawns".

This is the kind of warning that any investor tempted to go into cash or government bonds at today's prices should take seriously. Sure, bond yields could well go lower, and those who bet on that outcome stand a chance of looking wise for at least a week or two. But as with any kind of bubble, you will only come out ahead if you are content to operate on the basis of the Greater Fool theory.
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