Wednesday, September 17, 2008

The Perfect Financial Storm... "This, too, shall pass"

From the Desk of Joe Rollins

Monday will certainly be called a historic day in the history of stock market investing, and I couldn’t help but be reminded of that fateful day in October of 1987 when the Greenspan-inspired stock market crash occurred. On Monday, October 19, 1987, the Dow opened at 2,247 and by the end of the day, the market had fallen 22% to 1,739. It was a “Black Monday” indeed! Proclamations ensued that we should anticipate financial catastrophes and that another depression would soon sweep America. Sound familiar?

Today, even after the large market correction, the Dow is trading at the 10,900 level, which means that the market has gone up over 650% since the stock market crash of 1987. A long-term chart of the Dow Jones Industrial Average from 1950 through today reflects that the blip in 1987 hardly breaks the upward trend line. Putting everything into perspective certainly helps in understanding long-term investing.

Over this past weekend, I watched the demise of Lehman Brothers unfold. Even though there were certainly more important topics to discuss on this beautiful summer weekend, the only subject that seemed to gain any media attention was whether Lehman Brothers would be allowed to survive.

From a true financial standpoint, Lehman Brothers was nowhere close to bankruptcy. In fact, they had billions of dollars of very valuable assets. However, there was such a dramatic loss of confidence in Lehman Brothers that they were left with no liquidity to service their debts. And so, Lehman’s failure became self-fulfilling in that the more people talked about their negative financial situation, the more customers refused to work with them. It didn’t make any difference that Lehman Brothers had billions and billions of dollars of assets; without cash flow, they were effectively out of business.

Waking up on Monday morning, it was already apparent that the world was going to suffer a major meltdown from stock prices. However, I couldn’t help but be drawn to the fact that oil was trading down $6 a barrel to the mid-$90 range. The fact that the price of oil has gone from a high of $148 to a current price of $95 seemed to be much more materially important to most Americans. However, all the financial news concentrated on was the potential liquidation and bankruptcy of one relatively minor brokerage house in New York City.

The price of oil affects all Americans not only when we fill up our gas tanks but also because virtually every product has a price component that’s directly attributable to petroleum. The fact that oil is down 36% should give all Americans a large financial bonus in the coming months. With the nationalization of Fannie Mae and Freddie Mac last Monday, long-term interest rates fell dramatically. Currently, 30-year Treasury rates on home mortgages are below 6%. The positive coupling of lower petroleum prices and the reduced cost of mortgages ought to energize the economy in the upcoming quarter. In spite of that forecast, the media only reported the failure of this one brokerage house.

At Monday’s closing bell, the Dow had sold off over 500 points, but on a percentage basis, this is only 4.5% and is certainly nothing close to the 1987’s “Black Monday” loss of 22%. In any event, the psychological effect as a result of the headlines was just as damaging. Throughout the entire world, starting in the Asian markets on Tuesday, each market sold-off at substantially the same percentage, meaning that in the course of 24 hours, roughly $10 trillion of personal wealth evaporated worldwide as a result of a company that had a market capitalization of less than $5 billion. As a percentage, Lehman Brothers represented less than .016% of the loss in net worth the world suffered. Come on, folks – let’s get a grip!!

Don’t misinterpret what I’m saying – I realize that a lot of money was lost Monday and that’s it’s never easy to watch your investments go down, but Monday’s sell-off, unlike 1987’s crash, had no justifiable cause. In 1987, stocks were richly valued and had gone up consistently for almost five years in a row. The Fed had already started increasing interest rates and had dramatically slowed the growth in money supply, so there was a reason for 1987’s market correction.

What we endured Monday is completely different: The Fed has cut interest rates dramatically and injected literally billions of dollars into the economy to ease the liquidity crises. Countries around the world injected capital into their money supply on Tuesday morning to reinforce liquidity and to assure that banks could safely operate. Our Federal Reserve has moved quickly and brilliantly to strengthen the financial operations of banks in the United States. Stocks are now selling at absolutely unheard of low levels in my investing lifetime; wonderful companies are selling at fractions of their implicit value over the last decade. There was simply no reason for this past Monday’s market correction.

When investors lose confidence, they also lose the ability to properly evaluate market circumstances. I’ve always found it strange that when consumer goods are on sale, people flock to purchase them; but when stocks are on sale, everyone seems to run in the opposite direction. With stocks prices at such low levels right now, it’s hard to understand why more investors aren’t taking advantage of this opportunity.

The reason Monday’s sell-off started in New York is not necessarily because investors feared that Lehman Brothers would fail. Rather, many surmised that it would be the first domino to topple with many others falling afterwards. While it’s true that the Federal Reserve assisted in the recent Bear Stearns buy-out, it was also clear that the Fed had no intention of bailing out Lehman Brothers.

Last week, the government nationalized Fannie Mae and Freddie Mac and provided liquidity to the mortgage sector in America. It’s obvious that the government would prefer for all businesses to resolve their financial issues without its intervention, but it’s also just as obvious that the government intends to disallow significantly influential companies to affect the U.S. economy.

If you’re an avid reader of my posts, you probably recall that I’ve written before about the problems associated with the accounting methods that are now required in the United States for valuing various assets of corporations. Considering the turbulent market over the last few days, it’s time for me to revisit this topic.

After Enron blew-up in 2001, the accounting profession decided to rewrite the rules regarding valuing of assets. Up until that time, assets were recorded on the books of companies at their historic cost. Since that meant that the assets would never change value as long as they were owned, it afforded many businesses the opportunity to have assets recorded on their books that were worth significantly less. To solve this problem, the accounting profession required that corporations revalue their assets essentially at market value.

For major corporations, revaluing their assets at market value essentially means that they write-down the value of their assets to fair market value as of the balance sheet date. However, they never write them up if they happen to be worth more than the historic cost. This market valuation adjustment has been highly controversial, and as I’ll illustrate, it has also been very destructive to many U.S. corporations.

Inarguably, if an asset can’t be properly valued, it should be written down to its estimated fair market value. Requiring corporations to start valuing their assets on a fair market value basis was an attempt to get the balance sheets of those corporations on an essentially liquidation basis. The problem with this scenario, however, is that it creates enormous fluctuations in the capital structure of entities.

Using your own family budget as an example, assume that you own a nice house in a nice neighborhood somewhere in the United States in today’s slow real estate market. If you had to sell that house and create cash within the next 48 hours, what do you think you could get for it? What’s realistic – 90%, 80% or even 50% of its value in a forced sale situation? Further, assume that you have no debt on that house, nor do you want to sell it – your preference is to live comfortably in your paid-for house the rest of your life.

That’s essentially what is happening with valuations in these failing brokerage houses on Wall Street. They’ve purchased long-term investments with the full intention of holding them to maturity. Their intention wasn’t to trade these items, but rather, to enjoy the appreciation and cash flow that’s generated from these investments. However, because of the accounting rules, they’re now suffering severe losses on these investments since there is no market for them.

While some people argue that these companies should be valued on a fair market value basis, what if there isn’t a market for the investment? Coupled with the fact that the investments are illiquid and there is no current market for them, valuations – even at 50% – are considered to be aggressive. Even though the investments are performing as structured and the corporations continue to receive cash flow from them, they’re taking a hit in their capital because of these investments.

The effect, unfortunately, is that the capital of these companies erodes with write-downs in values, requiring them to seek outside capital. As investors in the common stock of these companies, we suffer the losses along with those companies.

Lehman Brothers certainly wasn’t required to declare bankruptcy due to its operations; the reason it had to declare bankruptcy related more to the loss of confidence that other brokerage houses and banks had with Lehman Brothers. By virtue of writing down Lehman’s investment assets to very low levels, their capital was eroded and their ability to borrow money was impaired.

Lehman Brothers was put out of business when they should have been allowed to continue. I’m not suggesting that the government should have intervened and bailed out Lehman Brothers; I’m simply suggesting that common sense should be exercised and proper valuations of investments should be taken into account.

You might think that I’m an island unto myself in making these radical suggestions regarding changing U.S. accounting methods. However, the SEC has also recognized this to be a problem and has recommended that U.S. companies adopt European accounting methods for valuing company assets. Under common European accounting methods, such large write-downs in long-term assets just do not occur.

On Tuesday, the Federal Reserve elected to leave the Federal Funds Rate unchanged. This clearly illustrates that the Fed believes the economy to be functioning normally. You may rest assured that if the Fed was concerned about the economy dipping into a deep recession, they would have moved to reduce interest rates.

Only two weeks ago we received notification that the second quarter 2008 GDP rate increased by 3.1%. Here were are only a few weeks later and many are forecasting the economy to turn into a prolonged, nasty depression. The reality is probably somewhere in between; while the economy certainly can’t be defined as strong at the current time, it’s still chugging along on an okay basis.

I encourage you to take days that are as dramatic as this past Monday with a grain of salt. These types of days reflect that traders on Wall Street are attempting to move the market to their own advantage. If you’re a long-term investor and you don’t need your invested capital for years down the road, then you should completely ignore these difficult days.

As has been proven in many studies, stock market investing is the most profitable form of investing over the long-term. While variations and extreme days can occur, over the long-term, investing in the market is most rewarding. I hope you realize that we’re watching your accounts closely and that we’ll take all necessary actions we believe are in your best interests. As it pertains to long-term trends, this past Monday means nothing.

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