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January 12, 2009
Dow Jones Average: 8,474
S & P 500 Index: 870
Saving American Capitalism
Proponents of capitalism believe fervently that it is the most effective economic system. In theory
the capitalist, free market system rewards innovation, efficiency in production and distribution, hard
work, responsiveness, and the wise allocation of resources. Different countries adapt the free market,
capitalist model to their preferences, incorporating social safety nets, financial regulation, trade
restrictions, wage requirements, price support programs, along with other elements of government
control and planning.
While the wealth generating aspect of capitalism has universal appeal, the boom/bust cycles
that occur with some frequency create social and political tension, and the misallocation of capital.
Government efforts to forestall the bust phase of the cycle can actually make things worse. We
believe that former Fed Chairman Greenspan’s low interest rate policy during 2002-2005, which
continued his pattern of rescuing financial markets, actually exaggerated the boom/ bust cycle in
real estate and financial assets. In a previous strategy update, written several years ago, entitled
“Greenspan’s Legacy” I forecast that his actions could lead to a financial collapse too big to contain.
It seems that the day of reckoning has arrived.
At the end of the day people don’t care about economic systems, they only care about outcomes.
With unemployment soaring, financial markets plunging, and the wealth gap widening, most people
are not happy with the results. In the past few years our economic system enriched people who
invented new financial products such as pick-a-payment mortgage loans, credit default swaps,
collateralized debt obligations, etc. The biggest financial rewards went to people who produced
nothing of lasting value. When an economic system rewards failure and misallocates resources
the repercussions for society can be severe. The policy mistakes of the Bush-Greenspan era have
damaged the system in ways that will take years to repair. The Obama administration is inheriting
a 1.2 trillion dollar annual deficit from the Bush administration, and that is before the proposed
stimulus package of 800 billion dollars.
President-elect Obama and his advisors understand that they need to move quickly and decisively
to break the downward momentum of the economy and restore confidence in the functioning of
American capitalism. In our opinion the goal of the large stimulus package is to inflate, inflate, and
inflate, while creating some needed infrastructure. Government policy makers would prefer to rein
in inflation a few years down the road than face deflation and depression now. Deflation is deadly
for those who are in debt. Falling prices cut revenue and incomes needed to service the debt. If
deflation takes hold the current debt implosion will accelerate. Inflation raises revenue and incomes
which makes it easier to pay down debts. The government has no choice other than to inflate the
economy at all costs.
Deficit spending and inflation have negative effects that will have to be dealt with later. If
inflation takes hold as planned and the economy recovers, taxes will be raised in a couple of years
to both shrink the budget deficit and provide subsidies to those who cannot keep pace with inflation.
Entitlement spending will also have to be contained in an effort to close the trillion dollar budget
deficits. One of the more enduring benefits of the Obama plan may be the focus on alternative energy
and medical information technology which, if carried out well, could improve the quality of life and
lessen the increase in energy and medical costs longer term. If the country comes out of this period
with a vastly improved medical, energy, education, transportation, and communication infrastructure,
some of the deficits being passed onto future generations will have been justified.
The Bernard Madoff Debacle
In mid-December, after suffering through one of the worst years in Wall Street history, investors were
further shaken by the news that a man named Bernard Madoff had been arrested and charged with
investment fraud on a massive scale. Madoff was the founder in 1960 of a securities trading firm
that specialized in over the counter (NASDAQ) stocks, and later on he started a hedge fund which is
the object of the fraud allegations. Madoff was a former chairman of the NASDAQ stock exchange
in the early 1990’s. He was known and revered in certain circles, but was unknown to most people,
including us, partly because he cultivated an air of exclusivity and secrecy. If the allegations against
him prove to be true, his name will live in infamy as the perpetrator of one of the most devastating
swindles in financial history.
The Madoff debacle is yet another black eye for the Securities and Exchange Commission.
The SEC failed to blow the whistle on Enron with its hundreds of shady offshore partnerships,
stood by as investment banks became insanely leveraged, and completely missed Bernie Madoff’s
alleged Ponzi scheme even though there were numerous warnings and allegations about his
operation dating back to the 1990’s. In a Ponzi scheme early investors are paid false “returns”
with money deposited by later investors. The strongest warning came from Harry Markopolos, an
accountant who first alerted the SEC about Madoff in May 1999, and followed up with a 21 page
treatise in 2005, taking issue with Madoff’s secret formula and his supposed returns. Markopolos
concluded that Madoff was either front running (an illegal activity to gain a market timing
advantage) or was more likely running a giant Ponzi scheme. The SEC is now doing an internal
investigation to determine why the agency failed to verify the allegations made by Markopolos and
others. Congressional hearings are also underway to explore why the SEC has been so inept at
uncovering serious cases of financial fraud.
Investors should be wary of entering into financial arrangements that take away control,
transparency, and accountability. Investors who had money with Bernard Madoff’s hedge fund
were in a situation where one company (Madoff’s) held their assets, had investment authority over
those assets, could pool the funds, and had unlimited power to move the funds to satisfy trades,
redemptions, or for any other purpose. From a structural perspective giving such power over one’s
account to a single organization with no outside (third party) verification is inherently dangerous.
With major banks and insurance companies failing, regulators asleep at the switch, and con men
on the loose, people are justifiably nervous. Such fears should not override a clear understanding
of investment management relationships and safeguards. The client relationship with a typical
money manager is very different than the arrangement people have with hedge fund managers.
Registered investment advisors (money managers) rarely hold client assets directly. The assets
are typically held at a large brokerage firm or bank in the name of the client. The custodian bank
or brokerage firm has the primary responsibility for ensuring the integrity of the assets and the
validity of any money transfers from a client’s account. Money cannot move from the account to
anyone other than the client (same name, same social security number) without a signed letter from
the client authorizing such a transfer. Clients receive statements from multiple sources, from the
bank or brokerage firm holdings the assets and from the firm managing the account. With multiple
parties viewing and reconciling a client’s account, and tight procedures covering withdrawals, the
possibility of any wrongdoing is extremely small. Unfortunately, investors who put money with
Bernard Madoff had no such safeguards.
Current Strategy
The stock market declined in 2008 by the third largest percentage in its history, eclipsing all other
down years except for two that occurred during the 1930’s depression. While stock valuations, as
measured by traditional ratios, have become far more favorable for buyers, the economic collapse
will continue to exert pressure on stock prices. The corporate revenues, earnings, cash flow,
balance sheets, and dividends that make up the currently favorable ratios will erode as the
economy continues to falter.
Over the past few months we have increased our clients’ exposure to stocks, buying into
companies that have stable revenue flow and strong balance sheets. We have also taken positions
in companies that should benefit from the Obama Administration’s focus on alternative energy and
health care information technology. While stock prices are enticing, our buying is tempered by
the severity of the economic crisis. We are maintaining large cash and short term bond positions
that can be used for further stock purchases depending on market and economic conditions. We
essentially have one foot in the market and the other foot out. The equity exposure level for our
typical, balanced account is substantially higher than six months ago, but still much lower than
the 1990’s level.
For the fixed income part of portfolios we are buying TIPS (U.S. Treasury Inflation Protected
Securities) at historically low prices. TIPS protect investors against inflation. Certain holders of
TIPS are unloading the bonds at distressed prices, because fear of inflation has been replaced by
fear of deflation. The shorter term (1 to 3 years) TIPS are now priced to yield between 3.5 and 6
percent over inflation. We think fears of deflation are somewhat overblown, and are eager to buy
the TIPS at favorable prices.
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