Out of Order, Call for
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
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
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
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!
Please read our important notice
about these letters and the securities they mention.