Letter - December 2008

 

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Out of Order, Call for Service

Nothing seems to work properly these days. The repairmen are struggling to set things right. “Call for service” is the mantra endlessly repeated by the press and on TV.

Plumbers in Washington at Treasury and the Fed are still trying to flush out the financial system with a flood of cash. In a bid to avoid bankruptcy, auto makers have convinced the White House to extend short-term bridge loans; but President Bush has left it to Mr. Obama and the new Democratic Congress in the New Year to find a sustainable solution to the industry’s troubles.

These are somber times. Unemployment is tragically rising; some say it will reach 10%. GDP for the final quarter of the year could fall 4%. The stock market has fallen 40% this year and real estate continues to decline even as mortgage rates sink to historically low levels. An alleged fraud at a Wall Street broker and money manager may have cost its customers $50 billion. Only those approaching their centennial year can remember a Christmas season so bleak.

The current recession began in November 2007, according to the National Bureau of Economic Research, the arbiters of such things. It could turn out to be one the longest contractions in a century. Our guess is that the worst of the economy’s decline will occur as we approach the spring, followed by a painfully slow recovery. We expect numerous bankruptcies to make headlines in 2009, particularly in commercial real estate as companies struggle to refinance loans coming due. Unemployment, which catches everyone’s attention, will continue to rise as the year progresses though we note that it is a lagging indicator of economic activity, often continuing to worsen even after the economy has bottomed.

Nonetheless, we caution clients against linear thinking, projecting trends indefinitely into the future. There are already a few encouraging signs that seeds are being sown for a turnaround.

President-elect Obama, forced by circumstances to move towards the middle, has muffled his mantra of change and chosen experienced, conservative and capable senior economic advisers. He has been flexible and pragmatic in his approach. Pledged tax increases on capital gains and dividends appear to have been deferred. It is no coincidence that the stock market began to stabilize as he announced his economic team.

At its December meeting, the Fed cut short-term interest rates to near-zero and introduced a number of measures designed to further lower long-term interest rates. The Fed’s intention, we believe, is to make returns on safe government securities and short-term debt unappealingly low, thereby giving investors incentive to take on more risk. A record $37 trillion is sitting in money market funds yielding 1% or less. Eventually, some of that money will leave in search of higher returns, creating demand for corporate bonds and equities.

We have often said that the stock market is a leading indicator and will turn before the economy does. We are encouraged by the fact that the market has been trading above its November low despite deteriorating economic fundamentals. The market for now seems to have discounted a lot of bad news. We remember well that the last great bull market began in 1982 while inflation was raging, interest rates were 14% and unemployment was surging.

We would be bold, indeed, to suggest that a new bull market was just around the corner. However, the shocking, across-the-board decline in stocks has created opportunities. Unwinding of leverage in the system has caused indiscriminate selling of high-quality stocks. Prices today reflect the systemic pressures facing the economy—too much bad debt, uncertainty and fear— rather than a realistic valuation based on long-term cash flows to investors. Large companies with strong balance sheets, lots of cash, little or no need for outside financing and a leading position in their industry have been driven to what seems to be bargain prices.

* * *

We are well aware that clients are upset with the performance of their accounts this past year. We feel every down tick in prices acutely, as we know that our success has always depended on clients’ continued confidence and long-term prosperity.

Fundamentally, we are value investors. We tend to buy stocks that have declined substantially and have modest valuations relative to their long-term prospects. This approach, which has served our clients well over the last fifty years, failed to protect against losses in the face of the most serious systemic failure we have ever experienced.

We believe that capitalism, despite the ferocious destruction from its periodic storms, represents the surest way to maximize individual and societal well-being. The markets, so central to capitalism, may be “out of service”, but they won’t be forever. As the flood of bad news begins to subside, we are confident that the tools that have served so well in the past will regain a sharp edge.

Fortunately, clients have substantial cash in their accounts. Investing that cash in depressed securities is usually the best way to recoup losses. We do not wish to encourage clients to go where they may not want to go. But this is a discussion we intend to have with you in the coming months.

* * *

Along with many of you, we find the news of fraud by investment manager Bernard Madoff deeply disturbing. We are shocked by the alleged magnitude of the fraud but even more so by the betrayal of trust.

We wish to remind clients that P.R. Herzig & Co. has explicit policies and procedures to protect our clients. All client assets are held in custody at Pershing LLC, a subsidiary of the Bank of New York Mellon that holds over $700 billion in client assets. All movements of funds or securities are reported on monthly account statements. As an additional precaution, Pershing notifies clients of these movements by mail the next day. We have great confidence in Pershing. They are conservative, professional and reassuringly bureaucratic. No short cuts permitted.

For over 50 years P.R. Herzig & Co. has adhered to the highest ethical standards. As holders of the Chartered Financial Analyst designation, our employees are held to a higher standard than is required by regulators. At the end of the day, though, our motto continues to be simply, “Do the right thing.”

Sumner, Arthur and Jon join me in wishing you a healthy and prosperous New Year!

Tom Herzig


 

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