Wait For It

Last week, we provided some perspective on our calls during 2007 – in short, we recommended investors take a cautious approach to stocks.  But we also offered up a few potential hedges (i.e. JPY, USD, GLD) which proved invaluable over at least the next twelve months.  In 2008, our advice was decidedly more mixed.  Let’s have a look:

Our first letter of 2008, stressed a well-known, but frequently disputed fact, that Bigger Really is Better.  We recommended that larger companies, which are often higher quality than their little brothers, should outperform in an environment of increased risk aversion:

“The underperformance in small cap stocks has the potential to reach similar levels seen in past cycles, as small caps currently trade at a 20% premium to the broad market whereas they have historically traded at a discount around bottoms in relative performance. The domestic-focused and more narrowly-based income streams of small companies suggest that they will lose favor as risk tolerance diminishes. As a result, the premium valuation currently accorded to small cap stocks should degenerate into a discount vs. large cap stocks as volatility continues its upward march.

Truth be told, hiding out in the SPYs (down 37%) or the OEFs (down 35%) in 2008, didn’t turn out to be the best hiding spot.  The IWMs even did a little better – losing a tad more than a third of their value.  But it is important to consider the composition of each index – pre-crisis, the large cap indices were heavily weighted towards the financial sector, which turned out to be a sinking anchor around the market’s ankles.  The XLF sunk roughly 55% during the year, so excluding large cap financials, higher quality large cap companies actually turned in a respectable degree of outperformance.

To be fair, our first quarter letter was not that specific.  The call was simply large over small.  However, our second quarter letter was quite specific.  The message was simply, Avoid Financials.

“The powerful short-covering rally in the bank stocks since the mid-July lows has alleviated some of the fears of imminent doom for the banking sector. But it remains clear that conditions are not yet in place for a period of sustained financial sector outperformance. Rather than viewing the process as nearly complete, we believe the first phase has now passed and we are now entering the most dangerous period of this adjustment process, as the need to cleanse the system of bad debts and paper will be challenged by government’s efforts to re-liquefy (i.e. bailout) the system, producing additional stress and potential fracture points.

“The combination of massive uncertainty as to the amount and distribution of near-term write-offs, another huge uncertainty as to the likely level of industry profits in the aftermath, and disturbing questions as to the quality of reported earnings in the sector suggest at the very least taking a deep breath before putting significant amounts of capital in the financial sector. Almost all investments we make involve taking on significant risks, but few investments seem to contain the level of unknowns that the US financial sector currently embodies. Buying them today may turn out to be a very profitable speculation, but it seems harder to consider it a true investment.”

We don’t need to remind you what happened to the stock prices of domestic financial companies in the second half of 2008.  It wasn’t pretty.  But the failure of Lehman Brothers did provide equity investors with their first opportunity to buy stocks at fair value in over a decade.  What was our response?

In the third quarter of 2008, as the S&P 500 hit an intraday low of 840, we published our first bullish letter on equities, suggesting that the market was Approaching a Bottom Granted, the market’s bear market trough did not develop until the first quarter of 2009, but Q3-08 clearly represented “peak panic” in our opinion, and long term investors did exceptionally well by shifting assets back toward equities late in 2008.  Let’s review what the local bear had to say, at a time when most investors we knew were bragging about how much cash they held in their portfolios:

“The best time to panic is before everyone else does. That was certainly an appropriate market stance in past quarters, when we cautioned investors about the growing risks of low quality debt (Q4-06), the unwinding of the carry trade (Q1-07), and urged investors to examine all risk exposure (Q2-07). But good investors love situations where panic is full blown and conditions appear utterly certain to get worse. When the news reports are uncontroversial in reporting that the U.S. is in recession, when they suggest that there is worse news ahead, and when they indicate that nothing seems to be helping, the market is more likely to register its low.

“While we may not be at such a low yet, the present sentiment of panic is typically one that presents useful opportunities for gradually scaling into market exposure, as uncomfortable as it might feel over the short term. This is what good investors get paid to do – not always immediately, but over time. The essence of good investing is to strike a balance. And while there is a good chance that valuations will eventually move lower still before a durable low is established, investors should recognize that given significantly improved valuations, compressed oversold conditions and an extreme spike in the VIX, the catalysts for a rebound are quickly accumulating.

“The most important thing about financial panics is that they are all temporary. They either die of exhaustion or are overwhelmed by the heavy artillery of government policies. That fact is worth remembering here. Ladies and gentlemen, the time to sell and raise cash was last year, not here. If your  exposure to risk is small, a panic is a good time to increase it, gradually, at depressed prices. That is what good investors do. Emotional investors establish leverage at tops and are forced to sell at bottom. Those investors unfortunately exist to a much larger extent than the former, but we are happy to provide them with liquidity when it is in furious demand. While this period has been very difficult and in some ways painful, the combination of massive and rapid financial delevering and unprecedented liquidity injections by global central banks, may prove to be one of the best potential buying opportunities we have ever seen. Market valuations have improved sharply, and the markets now appear priced to deliver favorable returns . . . at least for a while.”

Still bearish?  Not so much.  And if memory serves me correctly, about the only folks advising investors to buy equities after Lehman’s failure, were the same ones that recommended owning them in 2006-2007 as well.

As markets continued their steady decline, accompanied by an equally impressive decline in treasury yields, we highlighted the Bubble in Safety, in our Q4-08 letter to investors.  We know this might come as somewhat of a shock to those who have become accustomed to hearing “lower for longer” from Broyhill.  But the reality is we are, always, guided by price.  And as we stated in our first post in this series, “At the right price, we too, can and have been giddy bulls. At some higher price, we become less excited, and at a still higher price, we begin to earn the reputation of the local bear.”  Well, in the fourth quarter of 2008, with 10 Year yields hitting 50 year lows, we became quite bearish on treasuries:

“The panic in the financial markets has driven bond prices to speculative extremes. Unfortunately, unlike the stock market, where hopes and dreams can often sustain speculative markets for years, it is very difficult to sustain speculative runs in bond prices. The stream of payments for bonds is fixed and known in advance. In the event that the general level of risk aversion among investors eases, either the U.S. Treasury market or the value of the U.S. Dollar will endure disproportionately large losses. Given the level of extension in yields, it would not be difficult to generate losses of say 10% in the 10-year Treasury, and as much as 30% in the 30-year Treasury over a very short period of time.

“For our part, we continue to prefer Treasury Inflation-Protected Securities (TIPS), largely because TIPS prices now reflect  the prospect of sustained deflation over the next decade, in the face of a government that is issuing enormous volumes of liabilities and has nearly doubled the balance sheet of the Federal Reserve over the past 3 months. Normally, conventional Treasuries yield more than their inflation-indexed brethren because the extra yield is compensation for exposing one’s investment to the ravages of inflation. Conventional Treasuries only guarantee a nominal yield; TIPS guarantee an inflation-adjusted yield. Expecting some level of inflation is the normal state of affairs. But these aren’t normal times, so the yield premium for standard Treasuries has shrunk to almost nothing compared with TIPS. So if you expect inflation to one day return (as we do), buying TIPS is a no-brainer, since you currently don’t have to accept a lower yield relative to conventional Treasuries and at the same time you receive an inflation hedge at no extra cost.

“It helps to remember that the Latin root of the word “credit” comes from credere – to believe, but also to trust. For large  sections of the bond market, it is precisely that trust which has disappeared over the last year. The Government is now in the midst of the biggest expansion of monetary and fiscal stimulus perhaps ever. Although many people welcome the government doing what they can to arrest the decline in the economy and prop up the financial system – and perhaps it is far better than the alternative – one cannot turn a blind eye to the consequences. It may be that the current round of government intervention will be akin to wetting our pants: “At first it feels warm and comfortable, but after a short while it becomes cold and regrettable.” Let’s hope that the warm comfortable part lasts for a long time and that we are smart enough to change before the cold and regrettable part takes over.”

The white line in the chart above is the performance of TLT in 2009.  The green line – TIP.  Not many folks were out openly recommending a short sale of the world’s only true safe haven amidst the worst global financial crisis in the past century.  We’d guess that there were even fewer in 2008-2009, than those willing to buy treasuries when we suggested doing so after yields doubled from the panic lows hit in 2008.  That was a tough sell, but in 2010, we covered our Treasury shorts as yields spiked in late March and became buyers shortly thereafter, when we suggested that Later in the Year is Now!

My point is not to highlight how well we’ve traded treasuries during this cycle.  Our investors know we’ve gotten plenty wrong as well.  My point is simply that if one’s goal is to make money as an investor, holding on to a single view, be it bearish or bullish, is likely to leave you very frustrated and very broke. “The pessimist complains about the wind; the optimist expects it to change; the realist adjusts the sails.”

– William Arthur Ward