For stocks it sure seems like it. On the front page of today’s (12/20) Money & Investing Section of the Wall Street Journal, there is a great visual bar chart of stock market returns by decade. Guess which one ranks dead last? The 2000’s ending December 15, 2009. Its annualized decline of -.5% per year so far eclipses even the declines of the 1930’s! Similarly, the November 24th issue of Time Magazine ran a cover story called “The Decade from Hell.”

We’d like to think with improving (but not great) fundamentals and lower (but still not screamingly cheap) valuations, stocks are set up to do better in the next ten years than the last ten (not a high bar!). So if ever there was a time to say  “out with the old and in with the new”, this would be it!

Remember the guy in 2000 who predicted the Dow would go to 35,000? It was Harry Dent, author of The Roaring 2000’s. In that book, he argued that in the long run, stocks are no more risky than bonds, and therefore should have the same discount rate applied to their earnings. Conceptually his math was correct. If you apply a very low discount rate to a stream of earnings (or cash flow), you can produce enormous theoretical stock market values. It is now obvious his inputs into his discounted cash flow model were way off. His book was published right around the peak of the market in 2000.

So what is the good news? According to Forbes Magazine, Mr. Dent now has a book called, “The Great Depression Ahead.” He predicts the Dow is going to 3600. Let’s hope this prediction turns out to be as a good a contrarian indicator as his last one was.

Michael Lewis, author of Liars Poker, Money Ball: the Art of Winning an Unfair Game, and The Blind Side: Evolution of a Game, has once again put forth an important work that yields keen insight into the inner workings of Wall Street.

Lewis has compiled an excellent anthology of articles from modern day financial crises. Lewis reprints (along with some of his own commentary) some of the seminal news articles, white papers, interviews and government reports from past financial panics such as: the 1987 Stock Market Crash, The Asian Currency Crisis of 1997-1998, The Russian Debt Crisis of 1998, the Collapse of Long Term Capital, The “Dot-com” Crash of 2000, culminating in the current Sub-Prime Mortgage Crisis which unfortunately is not quite over.  Lewis lays out the articles in a way that captures the mood and sentiment before, during and after each crisis.

A few things are striking about the book. The first is the format. The anthology format allows the reader to skip around and focus on areas which are the most interesting to him. For example, I enjoyed the finer points of the policy dilemmas facing monetary officials during the Asian Debt Crisis. Do you raise interest rates to defend your currency (at the expense of already weakening exports), or lower them (and risk massive capital flight and deleveraging?) Lewis’s experience as a bond trader at Salomon Brothers yielded some very interesting insights into the debacle at Long Term Capital (“How the Egg Heads Cracked” which Lewis personally wrote for the New York Times in 1999.)

The second is how eerily similar each crisis seems to unfold. It’s almost as if there is a custom made template for financial panics. All you need to do is fill in new dates, the new financial instrument and change the names. The story is almost always the same: 

• A new financial innovation or asset class gains prominence.
• There is a view the innovation has tamed risk.
• The innovation produces fantastic gains for institutions.
• There is a central figure who rises to “rock star” like status and fame (think: Henry Blodget, Jack Grubman, and Michael Milken).
• Stories of ordinary citizens getting obscenely rich proliferate through the main stream media (“dot-com” day traders, Beardstown Ladies, condo flipping bar tenders etc.).
• A prominent member of the financial community stands up and warns of impending risk.
• They are ridiculed and dismissed.
• The bubble bursts.
• Panic ensues.
• The fall out is viewed as destabilizing to the overall financial system and the real economy.
• Congressional hearings begin.
• Society spends considerable resources trying to figure out how this could happen. It turns out no one knows how the first domino falls. The only common denominator seems to be a massive under pricing of risk. Lewis’s opening commentary on quantitative risk management (Value at Risk, Black Scholes etc) is particularly on point.
• Most importantly, once the panic ensues, in almost all cases, there is a prevailing view that the crisis is absolutely insurmountable.
• The storm passes.
• A new bubble forms.

My only complaint about the book is that it did not address the Real Estate Crisis of the early 1990’s, or the bursting of Japan’s Real Estate Bubble, both of which are much more akin to what is happening in America now.  Much of the book revolves around panic surrounding financial and quantitative innovation, however.

What are some of the broader perspectives investors can take away from reading the book? Risk cannot be tamed through mathematical models. They simply cannot predict how humans will react and adapt while under stress.

Panics crashes as well as opportunities have been around for centuries. The list of panics is long and they happen with alarming frequency.  The names, faces, dates and values change from crisis to crisis, but the story line stays the same. While this current crisis is a nasty and deep one, investors would be wise to remember the predictable story line of “Panic” also includes the word “Recovery.”

-Gerard Mihalick, CFA

Stocks were again volatile last week. The S&P 500 closed at 879 versus its close of 876 last Friday. The Dow closed at 8629, essentially unchanged from the prior week. There were plenty of gyrations throughout the week though.

For 2008, the S&P 500 and Dow are now down 40% and 35%, respectively. The S&P is up nearly 20% from its low of 741 which was reached in November. This intraday low actually eclipses levels dating all the way back to 2002.

The week started off with a large rally when President-elect Obama unveiled his plan for a large stimulus which focuses on infrastructure and energy build outs.

Later in the week, selling pressure began to mount. All eyes turned to the fate of the US automakers and potential economic fallout if they were to collapse.

Tension and selling pressure accelerated Thursday. Bank of America announced its plans to cut 35,000 jobs over three years (largely merger related). Also, JP Morgan CEO Jamie Dimon discussed that the U.S. bank is having a “terrible” November and December, blaming the “normal culprits:” mortgages, credit, high yield bonds and loans.

Friday morning, news that the Senate killed the auto bailout plan sent stocks sharply lower. Stocks regained their footing after the White House said it would be willing to extend the auto industry funds from the TARP (Troubled Asset Relief Program). The S&P climbed 6.7 points erasing a 3% loss. The Dow climbed 65, while the NASDAQ climbed over 2%.

More broadly, while equity market volatility and bad economic news remains the norm, we are  encouraged by the performance of equities over the last few weeks. There is now resilience, which is noticeably different than the swift and relentless declines witnessed in early to mid fall.

That period was punctuated by panic selling as investors started to come to grips with the depth and magnitude of the problems facing the world economy. Of perhaps greater magnitude, large financial institutions were in the midst of a painful process known as ‘deleveraging.’ Deleveraging is process whereby institutions (particularly hedge funds and large financial institutions) are forced to sell assets to pay down the lines of credit that are being called by their lending facility. Forced liquidations like this (unlike fundamental ones) create a viscous cycle. The more the market declines, the more participants have to sell, and the more participants have to sell the more the market declines. While painful, it is a curative process that takes excesses out of the system, which eventually can allow asset prices to rise going forward.

In contrast, market action from the November lows has been much more constructive. Yes, the market is higher, but even on “down” days the selling appears more “orderly” and not full of panic. Earlier in the fall, sellers met no resistance what so ever and totally overwhelmed any buying activity. The market wound up in what seemed like constant free fall. Not so of late.

Perhaps more importantly, we also are seeing several cases where worse than expected economic or earnings news comes out, yet stocks actually go up.

For example, on December 5 it was reported the economy lost over 530,000 jobs for the month which was far worse than expected. Yet, stocks rose sharply. This may indicate that the forced sellers are out of the market. Hedge funds are reporting high cash balances, which may signal at least a temporary respite from the deleveraging phenomenon.

Or, it may indicate stock prices were already so depressed they reflected horrible economic news – and then some. There is no rule that says stocks have to immediately settle to fair value – dislocations above and below true value can be large and persistent. Perhaps investors now can quantify the depth and magnitude of the recession (which officially began last year) and its impact on earnings (which most expect to be quite severe). This way, instead of worrying about which financial institution will fail next,  we can all look out to the other side of the canyon, and start assessing long term value, which is quite possibly higher than where we are today.

No one knows if we’ve hit bottom, and plenty of challenges remain. News flow will likely be negative for a while. But recent action has been more encouraging, however. If in twelve to eighteen months we are rewarded with substantially higher equity market values, we may look to this period, when stocks stopped going down on increasingly bad economic news that marked the turn.

Important Disclosure: The views expressed in this commentary and www.berkshireobserver.net reflect those of Berkshire Asset Management, LLC (Berkshire) as of the date of the commentary. Any views are subject to change at any time based on market or other conditions, and Berkshire disclaims any responsibility to update such views. These views are not intended to be a forecast of future events, a guarantee of future results or investment advice. Because investment decisions are based on numerous factors, these views may not be relied upon as an indication of trading intent on behalf of any portfolio. The information contained herein has been prepared from sources believed to be reliable, but is not guaranteed by Berkshire as to its accuracy or completeness. Past Performance is no guarantee of future results. Berkshire is an SEC registered investment advisor that manages accounts for individuals, institutions. A copy of our current ADV II is available upon request. References to particular securities are intended only to explain the rationale for the portfolio manager’s views and decisions with respect to such securities. Such references do not include all material information about such securities, including risks, and are not intended to be recommendations to take any action with respect to such securities. Investment Risk: All investments are subject to risk, including possible loss of principal. Because Berkshire Asset Management, LLC’s investment style expects to hold a concentrated portfolio of a limited number of securities, a decline in the value of these investments would cause the portfolio’s overall value to decline to a greater degree than a less concentrated portfolio. Our equity investment style may focus its investments in certain sectors or industries, thereby increasing the potential vulnerability to market volatility.

After listening to Congressional testimony and speaking with investors, it is clear people are confused about Treasury Secretary Hank Paulson’s $700 billion dollar plan to rescue the financial system. There are many details and nuances to be worked out, and success is in no way guaranteed. Below is a simplified discussion of how the plan is structured, and what the plan is trying to accomplish.

Many are mistakenly under the impression the government is planning on raising $700 billion and making some type of expenditure that gets vaporized into an ailing institution, leaving the tax payer with a “bill” of $700 billion. This is a categorically false understanding of the plan, both in mechanics and financial reality.

The US Treasury is planning on raising $700 billion so it can invest in high yielding mortgage backed securities (MBS) currently owned by our nation’s financial institutions. This does not constitute an expense; it is an exchange of cash for an asset. Mortgage related losses on securities have eroded capital so as to make it more difficult for many banks to make new loans, which is why this crisis is potentially devastating to the growth and health of the economy.

If executed properly, the plan could: allow financial institutions to get mortgages off their balance sheet, (while taking appropriate write downs), free up capital so institutions can once again lend, and actually make money for tax payers. Make money you ask? Yes. Here is how.

The Treasury is in the highly desirable position of being able to borrow billions of dollars for ten years at a measly 3.75% (the rate on treasury bonds). Under the plan, the $700 billion would be used to purchase mortgage backed securities with potential yields of 10-15% or even higher, depending on quality. Even if the government bought the most toxic debt and collected a few interest payments, they’d be in the money. Taxpayers would participate in gains as well as the losses. Every hedge fund in the world would love to have the government’s low borrowing advantage and the benefit of time.  What’s more, there are plenty of distressed, high yielding opportunities out there.

One should not conceptualize this as moral hazard, socializing losses or rescuing the “bad apples” that created the problem. This is more akin to the US taxpayer committing capital to participate in a hedge fund with a large structural advantage. There are many risks involved in a government venture such as this, but conceptually it is simple: borrow at 3.75%, invest at 15%, and pocket the difference on $700 billion. Simultaneously this plan provides much needed liquidity to reignite frozen markets.

Gerard Mihalick, CFA
Important Disclosure: The views expressed in this commentary and www.berkshireobserver.net reflect those of Berkshire Asset Management, LLC (Berkshire) as of the date of the commentary. Any views are subject to change at any time based on market or other conditions, and Berkshire disclaims any responsibility to update such views. These views are not intended to be a forecast of future events, a guarantee of future results or investment advice. Because investment decisions are based on numerous factors, these views may not be relied upon as an indication of trading intent on behalf of any portfolio. The information contained herein has been prepared from sources believed to be reliable, but is not guaranteed by Berkshire as to its accuracy or completeness. Past Performance is no guarantee of future results. Berkshire is an SEC registered investment advisor that manages accounts for individuals, institutions. A copy of our current ADV II is available upon request. References to particular securities are intended only to explain the rationale for the portfolio manager’s views and decisions with respect to such securities. Such references do not include all material information about such securities, including risks, and are not intended to be recommendations to take any action with respect to such securities. Investment Risk: All investments are subject to risk, including possible loss of principal. Because Berkshire Asset Management, LLC’s investment style expects to hold a concentrated portfolio of a limited number of securities, a decline in the value of these investments would cause the portfolio’s overall value to decline to a greater degree than a less concentrated portfolio. Our equity investment style may focus its investments in certain sectors or industries, thereby increasing the potential vulnerability to market volatility.

Equity markets in the US continue to show signs of recovery, with the S&P 500 gaining approximately 2.0% for the month of August. Berkshire portfolios continued their outperformance in August and are ahead of the market on a year to date basis.* Positions in Avis Budget Group (CAR), Leggett and Platt (LEG), Cisco Systems (CSCO), and Microsoft (MSFT) were positive contributors.

Foreign markets continue to struggle greatly this year, with many markets in Europe down 20% or more, and emerging markets such as Russia, India, and China are down 30% to 50%.

The reason behind much of Western Europe’s decline is those economies are beginning to experience some of the same problems the US has been facing such as slumping housing markets and a weaker economy. The dollar is having a great run versus the Euro, and is at a 2 year high versus the British pound. If Europe slows even more, a rate cut might also be on the table for the European Central Bank (ECB), which we think would likely add to the US dollar’s gain. The US dollar was surely a dark horse pick heading into 2008. We felt many world markets looked vulnerable based on many of the issues which are now coming to fruition.   

Emerging markets are coming to grips with other realities. First, we are seeing how the so called “BRIC” economies, (Brazil Russia, India and China) can carry significantly greater risks. Russia’s recent aggression illustrates that geopolitical uncertainty still comes with the territory of investing in these markets.

These markets are also coming to grips that difficulty in the US still greatly affects the rest of the world’s economies. For example, if the United States consumer was an entity unto itself, it would contribute 18.2% of the worlds GDP, which makes it larger than the entire economies of:  Japan (8.1% of world GDP), Germany (6.1% of world GDP), and The UK (5.2% of world GDP). China currently accounts for 6.1% of world GDP. So the consumer sector of the United States economy alone is 3 times the size of China’s entire economy. (Source: Bureau of Economic Analysis).  Lacking a consumption based economy of its own, much of China’s growth has been ignited by massive exports to the US consumer, who is likely cutting back in the wake of higher inflation, and a weak housing market.   

These deteriorating fundamentals coupled with rich valuations (China was 30 times earnings at the start of the 2008), has led to significant declines in many popular indexes in that region.  

New Purchase in Portfolios: Airlines

We recently added a small position in a major US airline to portfolios. Airline stocks have been very out of favor due sky-high fuel prices, and the threat of weaker economic activity. The difficulties in this industry have been well documented for years. However, we can make a strong case for a return to profitability and it is not just from the obvious catalyst of lower fuel prices, which of course would provide a big boost to earnings.   

What is not so obvious are some structural changes happening within the industry, namely capacity rationalization. The airlines have been cutting flights and retiring planes, which could have the highly desireable result of finally giving the industry pricing power. Revenue is made up of price times number of units sold. We think Wall Street has underestimated the pricing portion of this equation. It is the last available unit of a commodity that sets the market price. For example, if you were a widget producer with only unit left, but high demand, you would be able to command premium pricing. 

While the balance sheet and profitability metrics look challenging now, keep in mind the energy and materials companies looked very similar to airlines in the early part of the decade. They too were cutting capacity, but as the economy rebounded, demand outstripped supply, and pricing improved significantly. If a similar combination of lower fuel costs meets rebounding demand and constrained capacity, earnings can rebound rapidly in these companies, and would trigger what we believe would be an even greater rise in share prices.

*individual portfolio results may vary

Important Disclosure: The views expressed in this commentary and www.berkshireobserver.net reflect those of Berkshire Asset Management, LLC (Berkshire) as of the date of the commentary. Any views are subject to change at any time based on market or other conditions, and Berkshire disclaims any responsibility to update such views. These views are not intended to be a forecast of future events, a guarantee of future results or investment advice. Because investment decisions are based on numerous factors, these views may not be relied upon as an indication of trading intent on behalf of any portfolio. The information contained herein has been prepared from sources believed to be reliable, but is not guaranteed by Berkshire as to its accuracy or completeness. Past Performance is no guarantee of future results. Berkshire is an SEC registered investment advisor that manages accounts for individuals, institutions. A copy of our current ADV II is available upon request. References to particular securities are intended only to explain the rationale for the portfolio manager’s views and decisions with respect to such securities. Such references do not include all material information about such securities, including risks, and are not intended to be recommendations to take any action with respect to such securities. Investment Risk: All investments are subject to risk, including possible loss of principal. Because Berkshire Asset Management, LLC’s investment style expects to hold a concentrated portfolio of a limited number of securities, a decline in the value of these investments would cause the portfolio’s overall value to decline to a greater degree than a less concentrated portfolio. Our equity investment style may focus its investments in certain sectors or industries, thereby increasing the potential vulnerability to market volatility.