An Early Christmas?
September can be a treacherous month for the stock
market. This year, September arrived in July as troubles
in the credit market erupted, and Christmas came in
September as the Fed responded by lowering interest
rates. We haven’t looked in our stockings yet so we
don’t know if Santa Bernanke has left us goodies or
Few can claim to have been surprised by the fall in
real estate and the turmoil in the mortgage market. What
was a surprise was how events unfolded. Financial
engineering by Wall Street alchemists created complex
securities backed by bundled mortgages rated AAA despite
the inclusion of low-quality or sub-prime mortgages. As
recently as the late 1980s, most mortgages were held by
the banks that originated them. Since then, the trend
has been to securitize the mortgages by bundling them
together and selling them to hedge funds, money market
funds, and other investors. That, in theory, is a good
thing. A lot of investors owning a little bit of risk is
better than a few owning a lot of it.
As housing prices began to decline in the last year,
speculators and sub-prime borrowers began to default
causing the price of mortgage-backed securities to fall.
Furthermore, it became unclear what the underlying
mortgages were worth and how to value the securities.
Investors witnessed the reverse alchemy of gold being
transformed into lead. Ironically, because the risk was
so widely spread, usually a good thing, nobody knew who
had losses and how big those losses were. As a result,
there was a loss of confidence in the mortgage market.
Borrowers couldn’t borrow as lenders wouldn’t lend.
The credit crunch in the US soon became an
international event. Banks in Germany and England that
borrowed short to fund long-term mortgages were no
longer able to borrow short. They failed. Northern Rock,
a UK savings bank, even witnessed an old-fashioned run
on the bank, as nervous depositors queued for blocks in
order to withdraw their money. Institutions in Asia,
where mortgage debt is less common, seem to have avoided
the worst of the problems.
By the middle of August, the loss of confidence in
the credit markets spread to the stock market, which at
one point gave up its gains for the year, close to a
double-digit fall from the mid-July peak. A few hedge
funds failed and others, including some sponsored by
highly regarded Wall Street firms, dropped more than
20%. Fear was palpable. Who would be next?
As these dramatic events unfolded, the Federal
Reserve managed to have the calendar rearranged so that
Christmas arrived in September. It cut the short-term
Fed Funds rate by ˝%, and injected liquidity into the
credit markets, with calming effect and cheers all
around. The stock market rallied and has recently
exceeded its previous high. Credit markets have begun to
return to normal. But the outlook is far from clear. We
worry that there are still hidden losses in the credit
market that have yet to surface; this may further
destabilize the markets. As we enter October, third
quarter earnings reports will give a better idea of who
has been wounded and how badly.
It remains to be seen whether Fed Chairman Bernanke
is the Santa some claim him to be. Since the Fed lowered
interest rates, the dollar has been weak, raising the
cost of imports to US consumers and threatening the
economy with inflation. There are further concerns about
the effect of the housing bust on near-term consumer
spending, employment and growth of GDP. Interest rate
cuts can take six months to a year to stimulate the
economy. Will we have a recession before the effects
kick in? Can the stock market continue to rise in the
face of a recession?
The events of this summer present a cautionary tale.
While time and again Wall Street may try to convince
investors that it can weave a golden basket from a bale
of straw, in this case AAA-rated securities from
sub-prime mortgages, only gold remains gold. It is not
surprising then that the gold price has risen to its
highest level in almost 30 years (though adjusted for
inflation, its purchasing power falls far short of what
it was during the “golden age” of the late 1970s and
Gold has risen not just against the dollar, but
against currencies across the globe. This suggests to
some a flight from currencies in general. Or, is the
rise due to unprecedented demand by newly prosperous
consumers in emerging nations? Regardless of the “real”
reason, we interpret the rising global gold price to be
a significant event reflecting strong worldwide demand
that could fuel further price increases. While we would
not be surprised to see a temporary pullback, longer
term the trend looks to be up.
Long-term clients of P.R. Herzig & Co. have enjoyed
seven years of excellent returns. This year so far has
been an exception. Investments in financial stocks and
real estate securities have disappointed against the
backdrop of recent turmoil. We believe that they will
recover in time. Early investments in housing related
stocks have also hurt. Ace investor, Bill Miller of Legg
Mason, a big investor in homebuilders, has said that
being too early is the same as being wrong. Nonetheless,
we anticipate that the housing troubles could begin to
subside sometime next year and housing stocks should
rally months before. Meanwhile, many of the securities
that have performed poorly pay healthy dividends which
provide some return as we wait for the system to mend
The SEC requires us each year to offer to clients our
Form ADV II, which discloses important information on
how we manage client funds and run our business. You can
find the form (technically a “replacement brochure”)
here. Let us know if you would like us to
mail you a hardcopy.
The NASD, our other major regulator, recently merged
with the regulatory arm of the New York Stock Exchange
and is now known as the Financial Industry Regulatory
Authority, or FINRA. So far, little has changed except
Please read our important notice
about these letters and the securities they mention.