The recent catastrophes on the US Gulf coast, Katrina
and Rita, have prompted us to think about catastrophes
in general. Should events like 9/11 or the twin
hurricanes unduly alarm investors? Are they really as
isolated and improbable as we sometimes think?
As we think back over the last eighteen years, the
series of extraordinary events is itself extraordinary.
October 1987 brought the Black Monday stock market
crash. The one-day 23% decline would be the equivalent
of a 2400-point decline in the Dow Jones Industrial
index today. The 1980s ended with a full-scale real
estate collapse, forcing a $175 billion bail-out of junk
bond financed savings and loans institutions. Since 1991
we have been embroiled in five wars. The millennial year
started with a stock market bubble and ended with
another crash far more damaging than the first. Acts of
terrorism against US and other Western interests have
claimed thousands of innocent victims. The events of
9/11 brought war to the US homeland, shattering a false
sense of security for all Americans. Finally, hurricanes
Katrina and Rita brought widespread destruction and
suffering to the Gulf Coast. Oil prices spiked to
all-time highs with spot shortages calling up grim
memories of the 1970s.
If asked in 1986, we would have said that the
probability of any one of these high-impact events
happening was low. Yet history demonstrates that
high-impact events have a high probability of occurring,
though it is impossible to predict exactly where, when,
and how they occur. Shocks to the system are the norm,
not the exception. History is stormy not tranquil. Yet
despite the shocks, the American people and the American
economy have proved resourceful and resilient, and the
stock market has reflected this. With dividends
reinvested, a $1 investment in the S&P 500 at the end of
1986 (i.e., before the 1987 crash) was worth almost $8
by the end of September 2005, nearly a 12% annualized
return. Events of the moment rivet our attention. But
the market adjusts and moves forward. Phil Herzig, who
saw clients prosper through these and many earlier
crashes since founding the firm in the late 1950s, was
fond of saying, “The end of the world only happens
More insidious than sudden shocks, in our opinion, is
the regulatory creep that saps the vitality of what John
Maynard Keynes referred to as the “animal spirits” that
drive prosperity: entrepreneurial spirit and risk
taking. Class-action legal suits with sky-high plaintiff
awards do more than punish the improprieties of a small
minority of corporate managers. They hurt the retirement
funds of innocent shareholders (who ultimately pay far
more of the awards and fines than the errant managers).
And they discourage appropriate risk-taking by honestly
run businesses. How many life-saving drugs will never
make it to market because the catastrophic cost of
making a mistake?
When some latter-day Edward Gibbons chronicles the
Rise and Fall of the American Empire, we suspect his
emphasis will not be on the dramatic events of the day
-- market crashes, hurricanes, terrorist attacks, and
the like -- but on the slow creep of regulatory and
legal burdens that discourage risk-taking, raise costs
and pressure the profitability of American business,
that engine of our prosperity.
We have been surprised that our clients have done so
well so far this year relative to the paltry returns of
the overall market. The S&P 500 with dividends
reinvested increased only 2.8% through September 30.
However, the first three weeks of October have been
brutal. As of this writing, hard-won gains have been
paired back putting the S&P (though not yet our clients)
barely at breakeven. We try to remain cautious, keeping
new positions relatively small. Cash balances will
likely increase as we sell more than we buy. We are
becoming uncomfortable with price volatility as the
cycles for real estate and natural resources may be
coming off their peaks. As for the next great investment
idea, we don’t see it yet.
As always, clouds obscure the economic horizon. The
Fed is worried about inflation. Long-term interest rates
have begun to move up a little. Most of the blame for
recent signs of inflation is placed on the price of oil.
However, we are concerned about the possibility of
deflation as well. Consumer debt is high and housing
prices are down in the hottest markets. High oil prices
may act as a tax, draining dollars out of consumers’
pockets and weakening demand for other goods. Some fear
the Christmas season will be a wash-out. Does $40 in the
gas tank mean $20 less to spend at Wal-Mart?
We are watching gold prices for a clue to the
inflation/deflation outlook. The price of gold has
approached an eighteen-year high, though the charts give
scant indication as to whether the next move will be up
(inflation) or down (deflation). Ominously, gold is
appreciating against the euro and yen as well as the
dollar, suggesting world wide inflationary pressures.
Business meanwhile continues to be surprisingly good.
Retail sales and employment have stayed unexpectedly
strong in the face of the destructive weather. While the
hurricanes destroyed a tremendous amount of wealth,
business should generate extra income from the
rebuilding of the Gulf Coast.
We traditionally close our letters with a discussion
of our thinking about specific stocks in our clients’
portfolios. However, new compliance requirements limit
our ability to do so for the time being. We are in the
process of conforming to new regulations and will be
able to communicate our thoughts in future letters. We
hope that clients will contact us directly should they
be interested in specific actions on their behalf.
Please read our important notice
about these letters and the securities they mention.