DempseyTV

A fitting title as we begin Mar. 2009. Equity markets have been down six straight months. The Dow Jones was down 15 of the last 17 weeks.

There is a very strong tendency for people to exaggerate the importance of recent events and recent performance. It is human nature. You turn on the t.v., read a paper and whatever is on seems more important at the time than in retrospect. Probably the greatest mistake in investing is exaggerating the importance of, and extrapolating, what happened lately. What has happened over the last 3 and six months has substantially changed the psychology of a lot of people in the direction of betting these recent conditions will continue.

Floyd B. Odlum made a fortune in the Great Depression

So, I’d like to introduce you to Floyd B. Odlum, who died in 1976. He was an investor by profession, CEO of Atlas corp. Functionally he was an opportunist. He made a fortune in the Great Depression by buying up the deeply discounted shares of publicly traded investment trusts, the toxic assets of his day. We can have no finer role model in this, our Great Recession.

None of us can know the future, but like Odlum, we can make the best of a sometimes unappetizing present.

Let us travel back in time to 1930, the first time full year of the great slump. Nobody knew there would be a second such year, let alone a third. They were as much in the dark about the future as we are. In August 1933, the New Yorker magazine ran a profile of Odlum. “His cheerful behavior during this period was a recurring source of wonder and irritation to his friends.”

At one of the most painful moments in the country’s financial history, he was saying “I believe there’s a better chance to make money now than ever before.” As investors we are always so conflicted. We seek out bargains at the mall but shun them with our investment dollars. We loved internet stocks in 1999 at sky high prices, then hated them at $2 per share. Long term U.S. bonds are snapped up today at 3% yields but despised at 14% and more in the early 1980’s.

Odlum’s big idea was to buy dollar bills for 50¢.

Buying Dollar Bills for Fifty Cents

Great investors, world class opportunists, adapt to the times. What makes Odlum a guide and beacon for 2009 is that he saw across the valley of despair. Quoting from a Fortune magazine article about him from 1935: “He has no great faith in the immediate future of the market, whereas he was willing to bet his fortune on the market’s eventual future.” Odlum was bullish on America, as many of us are and should be. But he put money at risk only when the odds seemed right – when the investment has a price tag low enough to afford a margin of safety.

The silver lining of the Great Depression was of course, the prevalence of low price tags. Thankfully, to a lesser degree, it is the silver lining of our Great Recession.

Well, here we are, in the beginning of March 2009, and again in the grip of financial panic and fear. So many of you have spoken to me about what “they” say–”they” being what we all read and hear. And of course, none of us are immune to what “they” say… The “they” being media, experts and our own intelligent and informed friends. In no way does this minimize the obviously serious issues the global economy faces; however, it had me thinking about how those predictions have turned out…

Some Predictions

Let’s start in the late 1990’s with the internet boom and dot com stocks… remember that? No one would leave their house, we would all be “telecommuters.” We all know how that ended. But, in 1999, gold was $250 an ounce and oil was $10 a barrel. Did they talk about that? Gold recently hit $1,000 an ounce and oil hit $150 per barrel during summer 2008.

Then came Sept. 11th and the subsequent anthrax scare. Everyone said we would have multiple terror attacks coming and I’m sure a few of you bought duct tape and cipro for the coming biological/anthrax attack.

Next up was the ongoing bear market in stocks, that started in March 2000 and ended around March 2003. By that Spring, everyone knew stocks would keep going down and bonds/money market were the best investments… stock markets doubled from there!

Let’s see what’s next? Oh, of course, real estate! Remember all the t.v. shows, flip that house, etc. lines of people camped out overnight in Miami and Las Vegas, to get a ticket for the privilege of paying over asking price for a house/apartment…

Well, how about summer 2008 and oil hit $150 per barrel and gas $4 per gallon… they knew oil would be $300 and gas, $8! Remember that? Remember the Hybrid Toyota Prius, people waiting months and paying thousands over list price to get one… dealer lots are full of them. As recently as the beginning of this year, oil touched $25…

So, that brings us to today’s fear, panic and “end of days” talk, all of it with urgent certainty… hmmm let’s see….

Remember… no hard landing, and emerging markets will “decouple”? Remember the idea of what we call a soft landing–the economy will have a soft landing, and not a hard landing? Much of this analysis is just a sales pitch. Those are my thoughts on “they.” Thank you.

The title of this memo, as investors, says it all! It is audacious to be hopeful, these days, for anything. However, this is exactly why we must begin to adjust our thinking.

While we can’t know what will happen we can at least observe. With that in mind, we’ll observe the period from 11/20/1998 to 11/20/2008. The total return for that period matches the period from late 1928 to 1938! An annual compound loss of (2.58) or a cumulative loss of 23%; dividends included. By this calculation and observation, the stock market may have already discounted a 1929 –1933 type depression.

It is hard, even in our media-hyped fear mongering modern world, to envision that future circumstances would produce a depression with a total earnings wipeout and unemployment soaring to 25%.

Compare the current financial crisis to the war years: 1938-1942

Keeping in mind that the stock market deals with the future and what might happen while the news deals with what has happened, let’s look at the war years 1938 to 1942.

From the time global war was visible in 1938 to the blackest days of 1942, when the risk of losing the war was the greatest, the U.S. stock market fell 60%. This compares to a 52% top to bottom decline 10/09/2007 to 11/20/2008.

Some facts:

• 430,000 American lives were lost in that war.
• Between 50 and 72 million civilians/combatants were killed in that war.
• From 1939 through 1942, Germany and Japan were winning the war, perhaps soon to occupy and control the Pacific Rim, Europe and the Americas, including the U.S.
• In Europe, only England and Russia were not occupied and London was being bombed nightly.

From the actual start of the war in the Fall of 1939 thorough the critical turning point in 1942, the U.S. stock market fell 44% compared to the recent 52% decline. Now, some perspective, does this imply the risk of life, fortune, freedom, future prosperity and well being is greater now than it was back then? I think not.

• Is there any real risk of being ruled by foreign despots?
• Is there now the real risk of total confiscation of personal assets and wealth?
• Are our very lives now at risk?

To say today’s stock market risk factors are the greatest since the depression is absurd.

As a model for the current crisis the great depression does not stand up to even a cursory examination.

Catastrophic policy mistakes following the 1929 stock market crash

Two catastrophic policy mistakes transformed a severe economic downturn following the 1929 stock market crash into a deflation depression:

• General adoption of aggressive trade protectionism – There are no significant pressures now
• Federal Reserve allowed both widespread bank failures and a severe contraction in money supply, exacerbated by the gold standard.

It is clear from the speed, scale and radicalism of the Fed’s ongoing response to the “credit crunch” that they intend to not repeat that mistake. Clearly, they have learned something; with a different set of consequences that we’ll cover in 2009.

Other differences between the current financial crisis and that of the 1930s

There are other crucial differences with the 1930’s. Most bank deposits are now federally insured. Government spending forms a much larger part of the economy and significant components of it automatically rise if the economy declines. These “automatic fiscal stabilizers” are much larger than they were then. Furthermore these factors are replicated across the global as fiscal stabilizers exist in every economy now and bank deposits are widely protected.

Looking beyond

So this leaves us, like the stock market, looking forward to 2009 and beyond, looking to the “audacity of hope” and what can surprise us.

• The new president and leadership from Washington
• So far, crisis responses have been monetary. For 2009 they will be fiscal; evidenced by the President elects plan to create 2.5 million jobs. This is been repeated around the world.
• A plan to end the Iraq war
• Much lower interest rates
• Much lower fuel prices

While 2009 will have news headlines almost too unbearable to read, as investors, I am hopeful we have much to be optimistic for.

Today we are going to speak about what has been going on in the stock and bond markets here in October and November of 2008. What is going on is what I call liquidation sales.

When a store (or any other business) closes its doors and all assets are sold/auctioned off; it is called a liquidation sale.

These sales, sad for the seller, create opportunity for the buyer. Seasoned shoppers – those who are knowledgeable about what the merchandise being liquidated ‘usually’ costs – become excited about finding and buying good, quality items at deeply discounted prices.

Rarely does someone else’s liquidation sale prompt us as consumers to liquidate our own holdings even if we might have paid more for the same or similar assets in the recent past.

Quite the opposite – If we have the cash, we buy more. Liquidation sales are always for cash.

Investors join the selling frenzy

These recent weeks have witnessed many investors having exactly the opposite reaction to liquidation sales of financial assets. They are drawn to join the selling frenzy, rather than look for bargains to buy. Irrational behavior at its most obvious.

The liquidation sales have been made by various holders of financial assets – Investment banks, banks, hedge funds, investment funds, etc…

These holders are either going out of business due to excessive debt or forced to shrink the size of their portfolios due to customer defections.

Forced sellers must sell, usually at any price!

“Real money” investors are never forced sellers

All Pension Partners LLC clients are what I consider “real money” investors.

A “real money” investor:

• Owns the investments outright, without debt
• Has a longer-term time horizon
• Has good liquidity (cash) in the portfolio.

The above ensures that you are never a “forced seller” or forced into a liquidation sale.

It is strange to observe that many investors who hold diversified portfolios of financial assets suddenly feel a need to compete with the forced sellers in a crowded marketplace – thereby forcing prices even lower!

But that is exactly what happened in early October through November of 2008.

Bulk of the decline likely behind us

Many of you have asked me, “Is it over yet?”

Though there are no shortages of opinions about this, nobody really knows the answer.

I do know that the top to bottom decline of the S&P 500 from the 10/09/2007 peak to the 10/27/2008 recent low was about – 46%. This ranks the decline as the third biggest decline in the post WWII era.

No decline has been greater than 50% in the last 65 years. Not one.

This suggests that the bulk of the decline is behind us, not in front of us.

Central banks and governments around the globe are fighting the financial crisis and in January, the country will have new leadership.

It is not the time to join panicky sellers.

Eventually, fears subside, and the focus shifts back to fundamentals and values.

What else do we know?

Risk assets in the U.S. and throughout the world are cheaper than usual, because prices have declined so sharply during 2008.

By virtue of this cheapness, we believe the probabilities of favorable financial outcomes for today’s buyers of financial assets are much improved compared to most times.

We have the same belief for current holders of financial assets.

I appreciate your time - and in our next segment, we will be speaking about the “Lost Decade,” the decade from 1998 to 2008.