Friday, October 17, 2008
This week, hope re-entered the picture. After the most punishing decline in stock prices since the Great Depression, the markets heeded the call in last Friday’s email and went up nearly 1,000 points on Monday. Frankly, this rally offered me little comfort, because 1,000-point swings in either direction are not indicative of a healthy market.
However, believe it or not, this rally began last Wednesday. Last Wednesday was the first time in a while that I saw buyers entering the marketplace. Reading this market currently resembles trying to see through the Matrix (a movie you must rent to understand that comment), and my screen on Wednesday and Thursday had only traces of green on a canvas of red. The selling on Tuesday and Wednesday of this week had to be anticipated, given the pent-up sellers who refused to exit on downticks. Nonetheless, we saw another rally on Thursday. Again, buyers emerged. They exist! Amidst the grim economic data, the inconclusive earnings announcements and the articles considering the end of America’s supremacy, somebody bought stocks. Values had simply reached irresistible levels on too many issues. In fact, 1 in 10 publicly traded companies had more cash on their books than the value of their market capitalization, making them worth more dead than alive.
I believe we have now entered purgatory. Valuations are low enough, but we have too much uncertainty to expect an immediate up-trend. Government action has been announced, but not deployed. Until the markets get a chance to assess the impact of the programs, skepticism will act as a governor. While entering a trading range may not seem cause to celebrate, it’s certainly preferable. We could all use the rest.
The Next Bursting Bubble
The secret ingredient for hedge fund returns has turned into poison. Just as the investment banks were forced to either partner with real banks or perish due to their high leverage ratios and deteriorating collateral, the hedge fund industry may be the next frontline of the credit crisis. 8,000 funds existed at the start of the year, managing an estimated $2 trillion. Many of these funds relied on borrowed money to turn small returns into large returns. When these returns move against them, the downside can be amplified as well, and in this current environment, credit has become much less available for these strategies. This “de-levering” of the hedge fund industry can lead to tremendous selling pressure for the markets.
If the $2 trillion figure is correct, and the average fund borrows 1-4 times the underlying collateral, portfolio values should be somewhere between $2 trillion and $8 trillion. If 30% fail, $600 billion to $2.4 trillion in securities must be liquidated. The deepest and most liquid markets are the stock and bond markets, which would therefore have first priority in any dumping campaign. These liquidations have many causes: investor withdrawals, tightening lending, deteriorating collateral. Whatever the case, it presents tremendous downward pressure on markets as the buyers for these securities are staying on the sidelines.
Many of the most widely held stocks by hedge funds have been punished mercilessly. XTO Energy, for instance, a stock over-owned by hedge funds, has fallen 70% since July. To make things more interesting, the list of hedge funds’ top holdings is published, inspiring many funds, knowing that the forced liquidations are occurring, to simply short the list of top holdings. That’s cannibalism! But in these extraordinary times the premium is on survival.
This bursting bubble creates enormous opportunities for long-term investors. Using XTO from above as an example, it now attractively trades for 7 times earnings with a 2% yield. The run on hedge funds will likely continue for a couple of quarters as redemptions and de-leveraging continue. This will create two outcomes, greater volatility and better bargains. Better bargains will attract more committed capital. This is the stuff bottoms are made of!
I began my investment career in 1995. Over the last 13 years I have used many formulas to assess the value of securities. In the late nineties we relied on the PEG ratio. This relative measure simply compared a company’s growth prospects with its valuation (P/E). You could therefore justify paying 100x earnings for companies that were growing at 100%. Seemed reasonable enough, until they stopped growing and suddenly you owned a security worth 100x zero.
At no point since the late 70s and early 80s have absolute valuations been at this level. Forget the growth rates, forget trying to rationalize lofty valuations. Things are simply getting cheap. The entire market trades for twice book value (the liquidation value). Using the local paper, here are some of the P/E’s of our local favorites: AutoZone, 10, International Paper, 8, Mueller Industries, 7, Thomas and Betts, 5, Valero, 4. Two thirds of the Dow 30 have P/E’s below 10. Alcoa has a P/E of 5 and a dividend yield of 6%, AT&T pays 7% with a 7 P/E. Pfizer yields 8.5% with a P/E of 6. I am starting to tear up! Over the course of my short but eventful career, I have never seen valuations like these.
With a market as schizophrenic as this one, with technical traders in total control, with hedge funds feasting on each other, do not search for long term meaning in daily trading patterns. The way to win is to take advantage of this short-term stress. Perhaps Pfizer will succumb to the credit crisis, recession, and end of the world scenario. If it does, paying 6 times earnings will appear foolish. But they will pay you 8.5% to take the chance.
In the words of Warren Buffett in today’s New York Times: “I’ve been buying American stocks. This is my personal account I’m talking about, in which I previously owned nothing but United States government bonds… If prices keep looking attractive, my non-Berkshire net worth will soon be 100 percent in United States equities.” Good news indeed from such a storied investor!
David S. Waddell
Senior Investment Strategist
**The content included in this blog represents the opinion of W&A and is for informational purposes only. It is not intended to be construed as tax or legal advice by the recipient. Past returns of investment are no guarantee of future results.
***Any data reported in this blog has been compiled from the Wall Street Journal, Morningstar, Investors Business Daily, or various other informational internet sites.