First Quarter 2008 Letter to Clients

In considering First Quarter 2008 we are reminded of the old Chinese curse, “May you live in interesting times.”

It was, to put it mildly, a volatile quarter for the stock market. The reasons for that volatility have been endlessly dissected by the media and we won’t waste more space here revisiting the conditions that caused the deep decline in stocks. The more relevant question is: What have we learned?

In our mind, it is a case of re-learning something, a lesson that investors get taught time after time and then, just as surely as night follows day, forget again in short order:

There Is No Such Thing As A Free Lunch.

Or, to rephrase it in investment terms: There is no way around the risk/reward equilibrium. If there is such a thing as a Natural Law of Investing, it is that risk and reward are inextricably linked. If you are making a certain rate of return, then rest assured you are taking on an amount of risk commensurate with that return. You cannot magically get higher yields on cash holdings unless you increase the amount of risk you are taking. You cannot slice-and-dice risky mortgages, pack them into exotic derivatives, sell them to institutional investors and somehow escape the fact that, underneath it all, they are still risky mortgages. You cannot – as in the case of the big brokerage firms – greedily decide to start keeping those high-yielding derivatives on your own books instead of moving them through the market and feign surprise when those investments blow up and your balance sheet gets turned upside-down. You cannot invest in a hedge fund that had an 80% gain last year and not expect that at some point you will have a loss of similar magnitude.

It doesn’t matter how smart you are; just ask the financial engineers at Bear Stearns who created all those Byzantine mortgage investments with their super smart, 35-year-old Ivy League brains. You might avoid the day of reckoning for years, and in that glorious interval you will seem to be among the smartest people on earth, people who have found a new way to make an unholy amount of easy money while all the common folk are still mucking along in their pedestrian mutual funds. And then one day there will be a knock at your door and you will find it is The Market, and The Market is here to exact the cost of the risk you took.

And then the game is over.

It happened with Bear Stearns. It happened with the stocks. It happened with Long-Term Capital Management. It happened with Drexel Burnham Lambert. We could go on all the way back to the dawn of capitalism – to Tulip Mania – and never run out of examples. Risk and reward go hand-in-hand, and the more you try to concoct ingenious and disingenuous ways to get around that fact, the greater will be your fall.


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When that fall comes to those who knew better and let greed lead them astray, it is hard to have much sympathy. But in large-scale events such as the current credit-market crisis, there are always, sadly, a large number of innocent bystanders who get caught in the collateral damage. One vivid example currently playing out is with dubious investments known as “Auction Rate Securities” (ARS).

ARS are typically debt securities issued by municipalities, and while they are bond-like in their behavior, they have a unique aspect to them: Their interest rates are reset periodically in an open auction conducted by the big brokerage firms.

The problem in the current environment is that the market for ARS has dried up, and so auction after auction is “failing”, meaning that there are no buyers in the market. That means the value of the ARS is falling and, at the same time, investors can’t get their money out without selling for pennies on the dollar.

As the ARS market has frozen, legions of investors are now screaming that they were sold those securities by the big brokerage firms as “cash alternatives” – money-market like investments with a higher yield. Many such investors invested their short-term cash holdings in ARS and now can’t get the money out. Meanwhile, the brokerage firms, which used to buy up the ARS themselves to prevent the auctions from failing, have now “declined to participate”, meaning they are sticking all of the losses back on the investors. Who, of course, are the same investors who were apparently told by the brokerage firms that ARS were as good as cash.

At Capital Directions, our staunch belief is that “cash is cash”, and we do not believe in trying to find cash equivalents that are “almost as good” as cash. Money-market funds such as those we use in our clients’ accounts are strictly regulated by the Investment Company Act of 1940 and securities regulators. Money-market funds are not allowed to invest in anything other than short-term securities with minimal credit risk.

Clearly, the same cannot be said for the ARS sold by the brokerage industry to its clients.


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The steep decline in stocks in the First Quarter obscured the fact that, once again, a few key days of gains during the turmoil kept things from being much worse – if, of course, you were invested. That may sound like the proverbial moral victory, but it’s no exaggeration to say that if you aren’t in the market when those big days occur, you can add years to the time it takes to recover your losses.

We decided to take a look at the impact of missing some of the best days during First Quarter 2008 to see how deep the losses would have been had an investor missed out on them. Here’s the stark reality:

Advocates of market timing love to make a counterclaim to this point by asserting that it is better to miss the worst days in the downturn even if you miss the best days along with it. Interestingly, however, when we removed the three worst days from this quarter’s performance along with the three best days the investor would have achieved a return of -10.60%, which was worse than the S&P 500’s fully invested return of -9.50%. When we removed the five worst days along with the five best days the return was -9.50%, which is exactly what the buy-and-hold return was, except you would have had transaction costs and perhaps taxes to pay if you had been moving in and out of the market. The moral of the story is that, no matter how unpalatable it may feel, staying put is the best course of action even in – perhaps especially in – a significant market decline.

There is also a fundamental flaw in the logic that it is better to miss the worst days even if you miss some of the best days, too. To miss the worst days, you somehow have to identify them in advance, move out of the market and then correctly decide when to get back in. In contrast, the stay-invested approach assures that the investor will be in the market for the recovery because he never left in the first place. Investors who follow the stay-invested approach are guaranteed to get the best days, while the market timer must rely on clairvoyance to achieve success. And, as we like to say, if you’re clairvoyant you don’t need an investment strategy anyway.


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We have grown weary of what might be dubbed RECESSION WATCH 2008 looking at the daily media reports. It almost seems as if the reporters are looking for a giant meteor to come hurtling out of the sky at any minute: “Is that it? Wait…yes! There! There it is! The RECESSION! And it’s heading right for us! Aaaaiiiieeee!!!!

One might point out to them that a recession is part of a thing called “The Economic Cycle” (you may remember this from eighth grade). And the funny thing about “cycles” is that they are “cyclical”, which means that all is not lost just because the economy is in a temporary contraction. Here is a helpful illustration we, um, borrowed from Wikipedia to illustrate this incredibly complex concept:



We do not minimize the fact that a tough economy causes significant hardships for many people, or that a declining stock market is a painful experience for all of us. But, from an investment perspective, it’s not like we haven’t been here before and lived to tell the tale. And it is worth noting that, when the batch of economic reports came out in early April that seemed to confirm we are in a recession, the S&P 500 index gained about 5% over the next week. This is not at all unusual, because the stock market is historically a leading indicator of the economy, which means the market is always out ahead, frequently reacting in ways that seem to make no sense in the present economic environment. Not coincidentally, this is why individual investors as a group fail so miserably in their investing efforts – they are always reacting to where we have just been, while the market is looking forward.