Letter -October 2007

 

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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 coal.

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 early 1980s.)

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 itself.

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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 the name.

 

Tom Herzig


 

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