March 2009 Commentary

“Men, it has been well said, think in herds. It will be seen that they go mad in herds, while they only recover their senses, one by one.” - Charles MacKay

The world economy is undergoing a severe contraction. Employment has fallen steeply since last autumn and the unemployment rate in the US has moved up to 7.6%. The deteriorating job market, considerable losses of equity and housing wealth, and tight lending conditions have weighed down consumer sentiment and spending. In addition, businesses have cut back capital outlays in response to the softening outlook for sales as well as the difficulty of obtaining credit. In all, US GDP (real Gross Domestic Product) declined slightly in the third quarter of 2008, and that decline steepened considerably in the fourth quarter. The sharp contraction in economic activity appears to have continued into the first quarter of 2009.

This will be the longest and deepest recession since 1946. Nevertheless, the economy will certainly not be as bad as it was in the 1930’s when unemployment hit 25% and GDP fell 20%, but today unemployment may approach 10%, similar to many of the other post-war slowdowns.

Are there any reasons to be positive?

Contrary to almost everyone else, we are optimistic.

It is impossible to know how protracted or severe this recession will be. It all depends on the success of the policy responses. Lessons from the policies enacted in past recessions provide clues as to how we will navigate through the current environment.

Monetary policy ultimately ended virtually every recession during the postwar era; it will likely play the prominent role in ending this downturn as well.

The Federal Reserve (the US central bank) came late to the party. The downturn began in December 2007 and they did not begin an accommodative policy until nine months later, after the bankruptcy of Lehman Brothers. The result has been a recession that will be longer and deeper than the norm.

Since September the Federal Reserve has let out all of the stops. They drove the Treasury bill rate down to nearly zero and they added enormous liquidity to the economy. They appear prepared to do even more if the need arises. “The Federal Reserve will employ all available tools to promote the resumption of sustainable economic growth and to preserve price stability. In particular, the Committee anticipates that weak economic conditions are likely to warrant exceptionally low levels of the federal funds rate for some time.” (Monetary Policy Release December 16, 2008, Board of Governors of the Federal Reserve System.

In addition, Congress passed a huge fiscal stimulus package last week that includes new spending and tax cuts equal to five and one-half percent of the economy. These initiatives should begin to materially affect the economy in the summer.

We don’t typically engage in economic forecasting. We have no special skills that allow us to see the future better than others, and we know that the evidence is that no one can forecast accurately. Dr. Victor Zarnowitz who is credited with knowing more about the business cycle than anyone, concluded simply “The record of predicting turning points — changes in the direction of economic activity — is on the whole poor.”

Our investment strategy is based on assessing the economic value of businesses over the longer-term. By looking out over a three to five year period we are generally able to avoid the need to predict inherently unpredictable short-term economic changes, and to focus on longer-term individual company strategies and how they will impact their value.

The current global recession is abnormal and therefore it warrants abnormal consideration. We believe that the media and almost everyone else are focusing on the current data -- all of which is bad, we are in a recession after all -- and are ignoring the probable positive results of the enormous and unprecedented stimulus initiatives that are being enacted.

1. The Economy will recover.

“Over the long term, economic growth swamps economic fluctuations.” For 140 years, the fundamental relationship between business cycles and the trend of growth has been quite stable; the Depression of the 1930’s is the only exception. Throughout this long period, the US economy has grown at a 3% rate with regular but only minor deviations, and the recovery from these periods has actually launched the economy to new heights each time.

The Federal Reserve has dramatically expanded the availability of money in the last few months. On September 10, 2008 there were $47 billion of reserves in the banking system, about the same level as in 2005. By mid-February 2009 those reserves swelled to $870 billion.

This is good central banking! The Fed is acting boldly as lender of last resort, just as it should have done in 1930s, but failed to do. The reduction in the money supply is generally judged to be the main cause of the Great Depression. The behaviour of the Fed today is different. Just look at this chart.

The world looked pretty bad September 15, 2008 when the Fed let Lehman Bros. fail. Things are beginning to show signs of returning to normal. No doubt it will take longer than one would hope; it will be a gradual process. The important point is that the process has begun.

The global policy response to the current credit crunch has avoided repeating the mistakes of the 1930’. Instead, it has focused on delivering a massive dose of tax cuts, interest rate cuts, and spending increases.

In an article entitled “The recession will be over sooner than you think” Stanford University finance professors Nicholas Bloom and Max Floetotto point out that this change in policy suggests that the economy should begin to show signs of a turnaround by the summer of 2009:

“At the same time political uncertainty has dropped as world leaders have clarified their stimulus plans. As uncertainty falls the economy will rebound.

The heightened uncertainty after the credit crunch led firms to postpone investment and hiring decisions. Mistakes can be costly, so if conditions are unpredictable the best course of action is often to wait. Of course, if every firm in the economy waits, economic activity slows down. But now that uncertainty is falling back, growth should start to rebound. Firms will start to invest and hire again to make up for lost time. This is based on our detailed analysis of 16 previous financial, economic and politically driven shocks. After falling by 3% between October 2008 and June 2009, we forecast GDP will rapidly rebound from July 2009 onwards.”

We have consistently stated that we cannot predict the economy with any degree of confidence or accuracy. We can however make reasonable inferences about the outcomes of actions or policies particularly those with an extensive fact base of evidence of their impact. The evidence is very clear: highly stimulative monetary policy and/or large increases in federal government spending result in increased real economic activity in the short run.

2. The stock market bottom always occurs in the midst of the recession.

The stock market bottom has occurred in the midst of the recession in each of the ten economic cycles since 1950.

On average the declines in the economic cycle lasted eleven months with two – 1973-75 and 1881-82 – continuing for sixteen months each. Not surprisingly, each economic decline has been accompanied by a stock market decline.

* Current data are not necessarily the final data for this recession.

In every case, the stock market began to improve prior to the end of the recession; In other words, stocks start to go up while the news still looks hopeless.

3. Stocks are cheap.

There should be a rational relationship between the total market value of U.S. stocks and the output of the U.S. economy - its GNP. In an article he wrote for FORTUNE Magazine on December 10, 2001, Warren Buffett said, "If the percentage relationship (between the total market value of US stocks and GNP) falls to the 70% to 80% area, buying stocks is likely to work very well for you.”

We are at that point now. From this lofty perspective shares are cheap by historical standards.

We of course use an approach that looks at share prices on a company-by-company basis. From this vantage point, shares have never been cheaper.

Looking at stocks by any measure, however, takes you to the same place: Stocks in general are cheap.

Source: Robert J Shiller

Source: Sanford C Bernstein & Co

Source: MFC Global Investment Management, Kingwest Research

 Source: MFC Global Investment Management, Kingwest Research

Source: Robert Amott Financial Times March 22, 2008 Life and arts p. 4

4. Company selection will be very important in the post-recession market.

Both Bank of America and JP Morgan Chase expanded their reach by about one-third within the past year. Both bought a major mortgage lender and both bought a major investment bank. Will both companies benefit equally when the economy starts to recover and grow?

The world is not ending. The great majority of people will remain employed and make their mortgages payments. Life as we know it will continue. Successful investing always requires keeping things in perspective; this has never been truer than at the current time.

It is always tempting to wait for the bottom of the market to be reached (as if it would be obvious when it arrived). Such a strategy has proven over the years to be deeply flawed. Historically, little volume transacts at the bottom or on the way back up and competition from other buyers will be much greater when the markets settle down and the economy begins to recover. Moreover, the price recovery from a bottom is normally very swift. Therefore, an investor should put money to work amidst the throes of a bear market, understanding that things may get worse before they get better.

In summary, our message is a simple one:

1. The economy will come out of this recession – the best guess is summer/fall 2009.
2. The stock market has always acted as a leading indicator and should recover before the recession ends – the lead-time is historically been 4 months (in other words stocks go up when the news is the bleakest).
3. To get the best out of the recovery stock selection is more important than ever.