"To understand the Great Depression is the Holy Grail of macroeconomics. ... We do not yet have our hands on the Grail by any means."
-- Ben S. Bernanke, 1995
Dear Fellow Independence Fund Shareholder:
I have some bad news, and I have some good news.
The bad news is that it is now September, the month in which the stock market traditionally performs at its worst. Since 1929, the S&P 500 has dropped, on average, by 0.69% for the month.
The good news is that it's not September 2008. The casualty list from last September alone reads like a Who's Who of the financial world: Fannie Mae, Freddie Mac, Lehman Brothers, Fortis, Merrill Lynch, American International Group, National City Bank, Wachovia Bank, Dexia. Even Iceland suffered what Peter Bernstein would describe as an "irreversible event" when its three major banks all collapsed and pushed their debts -- which were 6 times as large as the country's gross domestic product -- onto the national balance sheet.
What may have frightened regulators the most, though, was news that the $66 billion Reserve Primary Fund, a money market fund, lowered its share price below $1, a move that essentially "broke the buck" and triggered sell orders of half a trillion dollars in money market funds over the following days. Only a $105 billion injection from the U.S. Treasury averted a collapse of the shadow banking system. If you want to point to a moment when the American economic system stood on the precipice, this was it.
On Sept. 19, 2008, Treasury Secretary Henry Paulson revealed the government's plans for the Troubled Assets Relief Program, which would help shore up financial institutions by buying up to $700 billion in illiquid mortgage-backed securities. Some observers point to the first two weeks of last September as being the period when the great American experiment with free-market capitalism died. Over the next six months, it certainly felt as though the American economy was dying.
Now I am become Death, destroyer of worlds
By the beginning of March, the Dow Jones Industrial Average had ticked below 6600, a loss of more than half of its peak value. Yet compared with many emerging markets, the Dow got off light. Virtually all signs pointed to a global economy in a tailspin: Investors pulled trillions of dollars out of the stock market, the bond market, anything with volatility, and they shoved their money into U.S. Treasuries or other risk-free assets. Their plan was simple: Stay out of the markets until they saw signs of recovery. But even in mid-March, after stocks had rallied ever so slightly, New York University Finance Professor Nouriel Roubini called the rise a "dead-cat bounce." Roubini, who had presciently predicted economic doom in 2006, believed the March rebound would soon "fizzle."
Since then, the American equity markets have staged a 51% rally, the largest in several generations, and have added $4 trillion in value. Many companies, big and small, around the globe have used their suddenly buoyant equity prices to opportunistically raise money, so they can pay down debt or generate much-needed working capital.
Meanwhile, many commentators and investors are still reserving their optimism, even in the face of a rapid rise in share prices and the trickle of good economic news suggesting that a global recovery may be starting. Often meeting the news with outright anger and disbelief, these modern-day Marvin the Martians ("Where's the kaboom? There was supposed to be an Earth-shattering kaboom!") have missed the global asset rally for two reasons. First, huge money isn't made when things go from "pretty good" to "really good." Instead, the biggest stock market gains have historically happened when things could be, in the words of Spın̈al Tap's Nigel Tufnel, "none more black," and then improve imperceptibly. In our current situation, the economy's decision to cease collapsing triggered a massive snap-back rally.
Market conditions and prognosis
The second reason for the backlash is that many people became wedded to their belief that the economy was collapsing and failed to consider that they might be wrong. After all, macroeconomic trends have confounded soothsayers and economists alike for millennia. Put another way, an investing thesis predicated on economic collapse leaves a whole lot of slightly less terrible -- and far more likely -- outcomes on the table.
Think about the Bernanke quote at the beginning of this letter. Even though Bernanke is a leading expert on the Great Depression, his lifelong study had not allowed him -- as of 1995, anyway -- to identify the root causes of the greatest period of economic distress in American history. Keep in mind that the Great Depression took place 80 years ago, is painstakingly well documented, and happened when America's financial system was relatively simple and self-contained. To think that anyone knows the eventual outcome of our current economic troubles does violence to logic and common sense in equal measure. Of course, the safer position would be to join the folks in the end-of-days crowd. After all, they have most of the evidence on their side, and the events of the past two years have reinforced their position.
Certainly, the domestic and world economies face substantial challenges. At home, the official unemployment rate sits above 9.5%, and that figure doesn't include people who are so discouraged that they are no longer looking for work. Including that group, under a statistic known as U6 unemployment, puts the jobless figure at 16.6%, according to the Bureau of Labor Statistics. Furthermore, if American consumers want to return to their pre-bubble liabilities-to-disposable-income ratios, more than $4.4 trillion in liabilities will have to be eliminated -- or income will have to rise, and that seems unlikely.
However, what's being missed regarding equity prices in this environment is the simple fact that markets are discounting mechanisms. If you think the world is ending, you will find no price low enough for you to invest, since the end of the world portends the end of value. But if the world isn't, in fact, ending, then securities priced as if it were are likely to be screamingly cheap. What's more, I've observed that a good existential scare is actually pretty good for companies. With a necessary focus on capital efficiency, they suddenly seem to turn in much higher returns on their assets.
Take two and call Ben in the morning
I count among my best friends a brilliant young doctor who once told me that the main difference between medicine and poison is "dosage." In other words, most medicines are essentially poisonous, but they are administered so that the benefit outweighs the harm. In what the British might call a "therapeutic misadventure," the recent death of Michael Jackson from a combination overdose of extremely powerful prescription drugs offers us a perfect example of the line between the two.
Still, in life-threatening situations, the risk to the patient is often higher should too little medicine be administered than too much. Such is the nature of a balance sheet-driven recession. There is a deflationary gap roughly equal to the rate of household savings plus all corporate debt repayment, and as Nomura Research's Richard Koo describes in The Holy Grail of Macroeconomics, one of the main lessons we can take from Japan's balance sheet-driven recession is that too little stimulus would have been far more calamitous than too much.
This is why I've been a supporter of Chairman Bernanke's actions and creativity as he's steered Fed policy in response to the economic crisis. Over the past year, the Fed has taken some fairly unprecedented steps: opening up the funds window to investment banks; increasing the Fed's balance sheet up to $2 trillion from about $900 billion, to plow liquidity into the financial system; establishing unprecedented levels of coordination with central banks around the globe. These steps represent a massive dose of medicine, but doing less -- let alone doing nothing -- could have been even worse.
Of course, now that we've taken the Doomsday Scenario off the table, we also have to face the daunting prospect that the way from here is truly uncharted. Although too much stimulus may be better in a balance sheet-driven recession, that stimulus is by its nature destabilizing, particularly if it's left in the system for too long. When a government runs a deficit, either it must borrow the money from someone or it risks massive amounts of inflation. Removing the stimulus in the right amounts at the right time, without sending the economy back into a recession, will require incredible skill. And at the moment the stock market is betting that Bernanke will succeed, the bond market is betting that he won't.
Our focus hasn't changed
At Motley Fool Funds, we have found that many of the craziest values available a few months ago have disappeared. In particular, lower-quality and smaller-capitalization names have rallied to extraordinary levels, and we've liquidated a few positions at full value. By the same measure, we're still finding plenty of undervalued opportunities, particularly overseas, in large-capitalization companies and in markets that suffered mightily in the past year.
One such undervalued company is Russian oil giant Lukoil, which you'll note is one of our top 11 positions. We don't take lightly our decision to invest assets in Russia, which is, and will remain, one of the world's most frightening markets. But Lukoil is a bit of an outlier among the largest Russian companies: It's invested heavily outside Russia -- including in the Northeastern United States and in Europe -- and is not dominated by an oligarch. According to a company presentation, Lukoil controls 1.1% of all global proved reserves and 2.3% of production, figures comparable with those at American oil giant ExxonMobil -- yet ExxonMobil's enterprise value is US$320 billion, while Lukoil's is US$50 billion, a small fraction of the value of its reserves alone. It won't take much to go right at Lukoil for the stock to do very well for us.
The open question is, of course, whether anything will go right. There could still be a "kaboom." We live in a world where the dominant financial theme is "reduce debt," which is a healthy thing except that it's massively deflationary -- and kaboom-inducing. Our strategy involves seeking out companies that will benefit from the components of global stimulus that have yet to be deployed, and to not venture too far out onto the risk spectrum without high confidence that the price we're getting is right. You should know that we have no intention to chase the market. Should investors decide to become euphoric, you're unlikely to find us attempting to keep pace by plowing into "hot" sectors.
As you can see, while the Independence Fund generated positive results in August, our performance did not track well against our benchmark. I have alternately heard the tenor of the August market described as being a "zombie rally" and a "bad bank rally." For the month, AIG rose 245%, Fannie Mae 232%, Freddie Mac 269%.
Also in August, the markets in Europe -- which we have underweighted -- outperformed many where we have exposure. The British stock market rose more than 6%, the Austrian market 11%, and the Swiss market 4.8%, whereas the Chinese markets endured a simply horrid month, with the Shanghai Composite dropping by 21%.
It bears mentioning that any exposure the Independence Fund has in emerging-market securities is higher than that of our benchmark, which measures the aggregate performance of 23 developed markets. As of Aug. 31, 2009, we have a 0% allocation in 14 of the markets that the MSCI World Index tracks, while we have invested capital in 16 markets that MSCI World doesn't account for.
In short, our performance is going to meaningfully diverge from our index, even in the short term. The individual companies we own may make us extremely happy, yet a 20%-plus down month in China is still going to affect our results -- even if, in our opinion, factors of investor fancy rather than fundamentals are driving the domestic Chinese market. We also remain substantially underweighted in financial companies, particularly banks (our only common-stock investment in a bank is in Turkey), as well as in information technology and health care.
As we enter September, please know that the team and I remain extremely optimistic about our Fund's prospects. Although the stock markets have enjoyed substantial rallies over the past six months, we believe there are still substantial bargains to be had. In the wake of a miserable year for corporate financial performance, many seem to forget that a measure of a company's attractiveness isn't how it has done over a random 52-week period, but rather how much money it can make over a full economic cycle. The financial power of our roster of companies is, in my opinion, immense.
Portfolio Manager, Independence Fund