The Case for Preservation
By Paul Lamont
November 30th, 2010
After the sharp recovery in 1930 which followed the stock market crash of 1929, American investors watched Europe as “Germany, Italy, Austria, Hungary, and Spain” all had banking “difficulties.” The Italian situation was “particularly severe” according to Charles Kindleberger in The World in Depression 1929-1939. “In the summer of 1930, a number of small and medium provincial banks began failing and were either taken over by other banks under the guidance of the Bank of Italy or furnished with state guarantees…”
These banking failures and bailouts tipped Europe back into Depression. As to why the global recovery of 1930 could not be maintained, Charles Kindleberger concludes: “It was not enough to make money abundant and cheap; credit worthiness had to be improved by reversing the outlook.”
“The fact that acute banking stress in Europe was in advance or contemporaneous with the U.S. bank panic of November and December 1930 should throw additional doubt on the widespread belief in the United States of a U.S. origin of the depression.” - Charles P. Kindleberger. The World in Depression 1929-1939. 1973.
With the failure of Greece and Ireland, a bailout of Portugal priced in, and trust in Spain, Italy and Belgium hitting all time lows, the case for preservation today has never been stronger. As we described last October, the failure in November 1930 of Caldwell and Company followed the European troubles and was the first U.S. panic of the double dip. Kindleberger gives us more insight into Caldwell & Co’s troubles:
“Caldwell had invested aggressively in low-grade municipal bonds on pyramided credit provided by his chain of banks and insurance companies. The collapse of the stock market and the spread between high and low grade risks in the bond market had kept him scrambling for cash to stay afloat.” - Charles P. Kindleberger. The World in Depression 1929-1939. 1973.
Should it be any surprise that municipal bonds have recently sold off which “could have far wider repercussions – for everything from junk-rated debt to blue-chip corporate borrowers” according to the Financial Times. In our August report titled The Perils of Complacency we noted the herd-like behavior of investors rushing into municipal bonds and recommended that “investors should be avoiding municipal bonds as well as any institution that is overloaded with municipal securities.” A few weeks later, we began warning of a bond market disaster. Rick Bookstaber, an adviser to the Securities and Exchange Commission on risk, agrees. He “sees uncomfortable parallels between munis and mortgage-backed markets, including opacity, over-reliance on ratings and leverage (since amassing future obligations to public employees to pay them less today is a form of borrowing).” According to the Economist, there has also been “an uptick in inquiries from hedge funds looking to profit from a muni crash. They hope the widely held view that muni defaults are unlikely will be proved as big a misconception as the notion that house prices never fall.”
As we explained last month, the reversal of the bond mania (of which the municipal market is a subset) will shut down the credit markets again and cause the unwinding of the financial system. Municipal bonds are merely the subprime loans this time around.
“The divergence between high and low quality issues reflects a drastic change in expectations and loss of confidence. It is especially marked in foreign A and Baa bonds (but not Aaa or Aa) which declined during all of 1929, recovered sharply until April 1930, and the started down again, ending in collapse in November and December. As Schumpeter put it, ‘People felt the ground give way beneath their feet.’” - Charles P. Kindleberger. The World in Depression 1929-1939. 1973.
Eventually, this will present patient investors with bargains of a lifetime. But one must be ready.
The Case for Preservation: Exit Bonds and Stocks
According to GMO’s Jeremy Grantham, investors shouldn’t feel “forced to choose between two overpriced assets. That is not always a terrific choice to make because there is a third choice, and that is, 'don't play the game and hold money in cash.” In addition, notice that high yield bonds and equities are trading almost exactly the same (Barclays Capital High Yield Very Liquid Index and the S&P500 Index). Diversification is not working. Only by holding cash and reducing your position size can one minimize losses. Let us repeat: A diversified portfolio of stocks and bonds does not reduce risk. Higher rates (due to fears of default) and uncertainty reduces the value of both.
Not Just Any Cash
In The Interpretation of Financial Statements, Benjamin Graham states: “For practical purposes the various kinds of cash assets may be considered as interchangeable.” But since 2007, various forms of cash have become illiquid. We only consider U.S. Treasury Bills as cash. This summer we noticed U.S. money market funds buying higher yielding European bank debt. As we warned in March 2008, beware of money substitutes.
The Full Cycle
Last month, we cautioned investors: “seek value, do not chase yield.” In August, we stated: “If History warns of a collapse in lending, then a herd of investors is likely rushing in, precisely when the prudent should be rushing out.” As the Wall Street Journal reports; “Retail broker Brian Rehling says he has been trying unsuccessfully to get his clients into stocks. But most of them, he says, still want to buy junk bonds, drawn by the relatively high returns.” Meanwhile; “A growing number of hedge funds and other professional investors that are getting out of junk bonds... As they exit, mom-and-pop investors are flooding in, along with mutual funds that are usually dedicated to other investments, like stocks and government debt. All are lured by the outsize returns delivered by the junk-bond market over the past 18 months amid tepid gains in stocks and rock-bottom yields on Treasurys.” This is a perfect example. The hedge fund manager scooped up bargains last year. As prices became too high, he cashes out with a nice profit (67% in one example cited). Novices and yield chasers who rely on past performance are buying at the top and will hold on as prices fall. They will either be wiped out or give up at the bottom and sell at a loss to a value investor looking for bargains.
We want to be the value investor looking for bargains.
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