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AMI Perspective On Current Economic Crisis March 09


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I recently finished research on the current economic crisis, including its origin, possible trajectory and effects on portfolio management. Please contact me if you have any questions.

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AMI Perspective On Current Economic Crisis March 09

  1. 1. Jacob D. Benedict AMI Investment Management A Perspective on the Current Economic Crisis | March 2009
  2. 2. Disclaimer This presentation is not meant for distribution The majority of graphs that represent data based upon current stock market levels included in this presentation were calculated in the first half of March 2009, when the S&P traded in the approximate range of 675-780 (a number of them employ the S&P closing level of 778.12 on March 17, 2009); please see relevant footnotes for further disclosure AMI Investment Management
  3. 3. As in every crisis, the main cause was far too large a mass of credits – that is, of debts – for the amount of cash in which they were redeemable. Trade and speculation had long been so active, and too often recklessly expanded, that this disproportion had become dangerous, and a menace to our safety…a serious reaction, a serious revulsion, was inevitable unless we moderated our pace and mended our ways…I could foresee that this vast and growing disproportion between the volume of credits and cash would finally lead to collapse… In every panic very much depends upon the prudence and control of the money lenders…this is tantamount to saying that all depends on the calmness and wisdom of the banks…if they lose their heads and indiscriminately refuse to lend, or lend only to the few unquestionably strong borrowers, the worst forms of panic ensue. - Explanation of the 1907 Panic by Financier Henry Clews in Fifty Years in Wall Street, published in 1908 AMI Investment Management
  4. 4. [C]onsider a turkey that is fed every day. Every single feeding will firm up the bird’s belief that it is the general rule of life to be fed every day by friendly members of the human race…the Wednesday before Thanksgiving, something unexpected will happen to the turkey. It will incur a revision of belief. - Nassim Taleb in The Black Swan AMI Investment Management
  5. 5. Organization [A] The Anatomy of a Financial Crisis [B] Where Do We Go From Here? [C] Thoughts on the Stock Market and Portfolio Management AMI Investment Management
  6. 6. Themes [1] While this financial crisis may be more severe, it is not historically unprecedented [2] Our nation, both consumers and firms, have been leveraging themselves for over a decade; it is unclear how painful the deleveraging process will be, but at some point it must occur [3] In order for the economy to work, the financial systems (i.e. the credit markets) must be restored to health AMI Investment Management
  7. 7. [A] Anatomy of a Financial Crisis A Perspective on the Current Economic Crisis | March 2009
  8. 8. A well known tradition in monetary economics…tells the tale of a business cycle upswing by what Fisher called [1] a displacement (an exogenous event that provides new profitable opportunities for investment) leading to an investment boom financed by bank money (and accommodative monetary policy) and by new credit instruments – financial innovation. The boom leads to a state of euphoria where investors have difficulty distinguishing sound from unsound prospects and where fraud can be rampant. It also can lead to a bubble characterized by asset prices rising independently of their fundamentals. [2] The boom inevitably leads to a state of overindebtedness, when agents have insufficient cash flow to service their liabilities. In such a situation a crisis can be triggered by errors in judgment by debtors and creditors in an environment changing from monetary ease to monetary tightening. [3] The crisis can lead to fire sales of assets, declining net worths, bankruptcies, bank failures and an ensuing recession. - Michael D. Bordo, Rutgers University and NBER AMI Investment Management
  9. 9. [1] The Boom Exogenous shock = dot-com crash Desire for real, income-producing assets (real estate) Easy money = historically low interest rates Greenspan and Fed fight the “deflation threat” Overindebtedness = mortgages to the roof Securitization markets and derivative products Unsound prospects and fraud = Ninja loans Assymetric systems and moral hazard The evidence = BUBBLE AMI Investment Management
  10. 10. Stocks, Housing, Int Rates During the Dot-Com Crash 1.60 7.0% 1.40 6.0% 1.20 5.0% Federal Funds rate Value of $1.00 1.00 4.0% 0.80 3.0% 0.60 2.0% 0.40 From Mar-00 to Oct-02: 1.0% S&P 500 fell -49.2% 0.20 CSXR-10 rose +37.1% 0.00 0.0% S&P 500 CSXR-10 Fed Funds Rate AMI Investment Management *Source: S&P, Yahoo, Federal Reserve
  11. 11. Real Mortgage Rates (Mtge - TTM Infl) 12.0% 10.0% 8.0% 6.0% 4.0% 2.0% 0.0% -2.0% -4.0% AMI Investment Management *Data through March 5, 2009; Source: Federal Reserve
  12. 12. Comparitively High Real Estate Income Yields 12% 10% 8% 6% 4% 2% 0% Jan-02 Jan-03 Jan-04 Jan-05 Jan-06 Jan-07 Jan-08 Jan-09 ICF Dividend Yield 10-yr Treasury Rate AMI Investment Management *Data through March 2, 2009; Source: Yahoo, Federal Reserve
  13. 13. [2] State of Overindebtedness Households borrow beyond their means, spurred by financial innovation and excessive risk-taking Growth of securitization provides consumers a new source of funds Financial institutions employ leverage to magnify earnings Derivative products held on the books, difficult for regulators and investors to gauge risk Local and federal governments continue to run large deficits AMI Investment Management
  14. 14. Asset Backed Securities – Securitizing Mortgages Tranche A (senior) Asset #1 Principal = $75 million Asset #2 Return = 6% Asset #3 Rating = AAA Big Deal … … … Tranche B (mezzanine) … Principal = $20 million … Return = 10% … Rating = BBB … … Asset #N Tranche C (equity) Principal = $5 million Principal = $100 Return = 30% million Rating = NR AMI Investment Management
  15. 15. 45% Sources of Funding: 40% 1. Banks 2. GSEs 35% 3. Securitization Markets 30% 25% 20% 15% 10% 5% 0% 2000 2001 2002 2003 2004 2005 2006 2007* Alt-A/Suprime as a % of Total MBS Outstanding Alt-A/Suprime as a % of Total MBS Originated *2007 represents 1st quarter for amounts outstanding and 1st seven months for amount originated AMI Investment Management *Source: Federal Reserve, UBS, Gary Gorton
  16. 16. Shadow banks = hedge funds, investment banks, insurance companies and structured financial conduits (i.e. buyers of securitized products) AMI Investment Management *Source: Bianco Research, Pimco
  17. 17. Credit Default Swaps Still, with just over 12% of the mortgage market comprised of subprime loans, how did it bring down the entire economy? Credit Default Swaps (CDS) allowed everyone to get into the game Valued at over $40 trillion (notional) at FYE 2007, nearly equal to the total market cap of all publicly traded companies in the world as of Aug-08 (note: not all subprime) What is a CDS? – a “life insurance” policy for bondholders The catch – it doesn’t have to be your life AMI Investment Management
  18. 18. The Problems with CDS Don’t behave the same way as life insurance policies (AIG) The models are flawed – correlations change in times of crisis; the “turkey problem” and default rates Instead of lessening risk, they dramatically increased systemic risk Counterparty web difficult, if not impossible, to entangle…everybody depends on everybody Introduces leverage on company’s balance sheets that is extremely hard for investors to detect and monitor No system for comprehensive regulation AMI Investment Management
  19. 19. The Danger of Leverage Upside Downside Equity Structure: Unleveraged Leveraged Unleveraged Leveraged Debt, 6% 0 700 0 700 Equity 1,000 300 1,000 300 Income Statement: Revenue 100 100 50 50 Expenses 25 25 20 20 EBIT 75 75 30 30 Interest Expense 0 42 0 42 EBT 75 33 30 -12 Taxes (35%) 26 12 11 -4 Net Income 49 21 20 -8 Return on Equity 4.9% 7.2% 2.0% -2.6% Room for Asset Devaluation -100.0% -30.0% -100.0% -30.0% AMI Investment Management
  20. 20. Derivatives are dangerous. They have dramatically increased the leverage and risks in our financial system. They have made it almost impossible for investors to understand and analyze our largest commercial banks and investment banks… Improved “transparency” – a favorite remedy of politicians, commentators and financial regulators for averting future train wrecks – won’t cure the problems that derivatives pose. I know of no reporting mechanism that would come close to describing and measuring the risks in a huge and complex portfolio of derivatives. Auditors can’t audit these contracts, and regulators can’t regulate them… Derivatives contracts…often go unsettled for years, or even decades, with counterparties building up huge claims against each other. “Paper” assets and liabilities – often hard to quantify – become important parts of financial statements though these items will not be validated for many years. Additionally, a frightening web of mutual dependence develops among huge financial institutions. Receivables and payables by the billions become concentrated in the hands of a few large dealers who are apt to be highly-leveraged in other ways as well. Participants seeking to dodge troubles face the same problem as someone seeking to avoid venereal disease: It’s not just whom you sleep with, but also whom they are sleeping with. Sleeping around, to continue our metaphor, can actually be useful for large derivatives dealers because it assures them government aid if trouble hits. In other words, only companies having problems that can infect the entire neighborhood – I won’t mention names – are certain to become a concern of the state (an outcome, I’m sad to say, that is proper). From this irritating reality comes The First Law of Corporate Survival for ambitious CEOs who pile on leverage and run large and unfathomable derivatives books: Modest incompetence simply won’t do; it’s mindboggling screw-ups that are required. - Warren Buffett in the 2008 Berkshire Hathaway Annual Report AMI Investment Management
  21. 21. The Deterioration in Mortgage Processing and Quality A focus on quantity, not quality by mortgage brokers and bankers No retention of default risk Down to the department level Assymetric payoffs for bankers A reliance on complex models, historical data and credit approval automation A supposed “win-win” for the banks, whether the homebuyer defaults or not, as long as housing prices continue to rise Fraudulent and predatory lending practices e.g. – NINJA loans Option ARMs A dangerous self-reinforcing cycle AMI Investment Management
  22. 22. And it is not only households…it is firms, states, municipalities and the federal government AMI Investment Management *Source: Advisor Intelligence
  23. 23. Real Housing Prices and Year Over Year Change 250.00 0.2 0.15 200.00 0.1 0.05 150.00 0 -0.05 100.00 -0.1 -0.15 From Feb-97 to Dec-05: 50.00 Nominal Total Returns: 184.6% -0.2 Nominal Annual Returns: 12.6% 0.00 -0.25 Real CSXR-10 Index Year Over Year Change AMI Investment Management *Data through December 31, 2008; Source: S&P
  24. 24. [3] The Crisis Securities tied to mortgage loans had seeped into every corner of the system Default rates began to trend much higher then the models called for (partly as the result of the deterioration in quality and ARMs adjusting) Rating agencies begin to downgrade mortgage-backed securities, causing a fall in prices As prices fall, firms “mark assets to market” and post losses, requiring additional capital and collateral The call for additional capital and collateral further threatens the financial standing of firms Fall in real estate prices effects consumer spending, further pressures default rates AMI Investment Management
  25. 25. Important Events 3.16.08 – Bear Sterns acquired for $2 a share by JP Morgan, with backing from the Federal Reserve 7.11.08 – IndyMac seized by the FDIC 9.7.08 – Federal takeover of Fannie Mae and Freddie Mac 9.15.08 – Lehman Brothers files for bankruptcy 9.17.08 – The Reserve Primary Fund breaks the buck 9.17.08 – The Federal Reserve lends $85 billion to AIG 9.25.08 – Washington Mutual is seized by the FDIC 10.3.08 – President Bush signs into law the Emergency Economic Stabilization Act 10.6.08 – Stock market has worst week in 75 years AMI Investment Management
  26. 26. AMI Investment Management *Source: JP Morgan
  27. 27. 10-yr Levels on S&P 500 1,800 1,600 1,400 1,200 1,000 800 600 400 Last 10 Years: Nominal Total Returns: -40.0% 200 Nominal Annual Returns: -5.0% 0 AMI Investment Management *Data through March 17, 2009; Source: Yahoo
  28. 28. Still in the thick of it… The importance of credit and faith in counterparties The threat of deflation Mark-to-market and continuing debt-deflation spiral The massive de-leveraging cycle AMI Investment Management
  29. 29. AMI Investment Management *Source: Wikipedia
  30. 30. Spread Between 10-yr Treasuries and Aaa, Baa Corps 7.00% 6.00% 5.00% 4.00% 3.00% 2.00% 1.00% 0.00% -1.00% Aaa/10-yr Spread Baa/10-yr Spread AMI Investment Management *Data through March 5, 2009; Source: Federal Reserve
  31. 31. [B] Where Do We Go From Here? A Perspective on the Current Economic Crisis | March 2009
  32. 32. The first major financial crisis of the 21st century involves esoteric instruments, unaware regulators, and skittish investors. It also follows a well-trodden path laid down by centuries of financial folly. Is the “special” problem of sub-prime mortgages this time really different? Our examination of the longer historical record, which is part of a larger effort on currency and debt crises, finds stunning qualitative and quantitative parallels across a number of standard financial crisis indicators. - Carmen M. Reinhart, University of Maryland and Kenneth S. Rogoff, Harvard University AMI Investment Management
  33. 33. Reinhart/Rogoff Data Construction of a comprehensive historical database Includes emerging markets – may react more severely Average Decline Average Duration Entire Data Set Comps U.S. Comps U.S. US Data as of Fall in Real Housing Prices 35.5% 31.6% 6.0 years 3.1 years 31-Dec-08 Fall in Real Equity Prices 55.0% 51.2% 3.4 years 1.4 years 17-Mar-09 Increase in Unemployment Rate 7.0% 3.7% 4.8 years 1.9 years 01-Feb-09 Fall in Real GDP per Capita 9.3% 2.1% 1.9 years 0.5 years 31-Dec-08 Increase in Real Value of Govt Debt 86.0% 31.3% 16-Mar-09 AMI Investment Management *Source: Reinhart and Rogoff, Federal Reserve, US Treasury
  34. 34. Other Comparisons… Average Decline Average Duration Great Depression (1929) Depr U.S. Depr U.S. US Data as of Fall in Real Housing Prices 11.0% 31.6% 7.0 years 3.1 years 31-Dec-08 Fall in Real Equity Prices 64.0% 56.0% 4.0 years 1.4 years 17-Mar-09 Increase in Unemployment Rate 22.0% 3.7% 4.0 years 1.9 years 01-Feb-09 Fall in Real GDP per Capita 28.0% 1.7% 4.0 years 0.5 years 31-Dec-08 Average Decline Average Duration Japan (1992) Depr U.S. Depr U.S. US Data as of Fall in Real Housing Prices 36.0% 31.6% 17.5 years 3.1 years 31-Dec-08 Fall in Real Equity Prices 59.0% 51.2% 3.0 years 1.4 years 17-Mar-09 Increase in Unemployment Rate 11.0% 3.7% 2.0 years 1.9 years 01-Feb-09 Fall in Real GDP per Capita 1.0% 2.1% 1.0 years 0.5 years 31-Dec-08 AMI Investment Management *Source: Reinhart and Rogoff, Federal Reserve, US Treasury
  35. 35. 1.8 1.6 1.4 Std. Unemployment Rate 1.2 1.0 0.8 0.6 0.4 0.2 0.0 # of Months Since Market Bottom Jun-49 Oct-57 Jun-62 Oct-66 May-70 Oct-74 Aug-82 Oct-90 Oct-02 AMI Investment Management *Source: Federal Reserve
  36. 36. Number of Months Between Market Bottom and Maximum Unemployment 30 Average = 12.4 months Median = 10.0 months 25 20 15 10 5 0 AMI Investment Management *Source: Federal Reserve
  37. 37. Markets and Recessions On average, markets bottom 6 months before the end of the recession; market almost always begins to advance strongly 3 months before the end of the recession AMI Investment Management *Source: John Hussman
  38. 38. The Government’s Blueprint [1] Stave off financial crisis and massive panic [2] Restore the health of the credit system [3] Restore economic growth (consumption) [4] Prevent future crises AMI Investment Management
  39. 39. 1.20 Great Depression, peak to trough, S&P 500 falls nearly 90% As of 3.17.09, S&P 500 has fallen just over 50% 1.00 Value of $1.00 in S&P 500 0.80 0.60 0.40 0.20 Would have to fall an additional 69% to match the Depression 0.00 Number of Months Since Market Peak Great Depression Current Crisis AMI Investment Management *Data through March 17, 2009; Source: Robert Shiller, Yahoo
  40. 40. Mistakes of the Depression – Federal Reserve #1: Tightened monetary policy in 1928 despite economic weakness (meant to purge speculators) #2: Adherence to the gold standard forced further tightening of interest rates Economists later discovered that the length of time a country struggled with depression was directly related to how long they maintained the gold standard #3: Failure of Federal Reserve officials to recognize the importance of REAL interest rates as they eased policy in 1932 #4: The Federal Reserve’s ongoing neglect of the national banking system Also at issue: Smoot-Hawley Tariff Act Current Federal Reserve Chairman Ben Bernanke is a renowned scholar of the Great Depression AMI Investment Management *Source: Milton Friedman, Anna Schwartz, Ben Bernanke
  41. 41. The Tale of Two Crises: Japan and the Nordic Countries In the early 1990’s, both Japan and the Nordic countries suffered severe recessions (in the midst of a global recession) precipitated by an asset bubble in real estate In Sweden (the crisis also occurred in Norway and Finland), the crisis began in 1991, but was (relatively) quickly resolved and did not have a “major impact on economic developments from 1993 onward” By 1997, all assets taken over by the state had been sold, and some claim the country earned a profit In Japan, the country experienced the well-known “lost decade” following the crisis By the late 1990’s, non-performing assets comprised 18% of GDP AMI Investment Management
  42. 42. Nikkei 225 - Japanese Stock Market 450 Hundreds Since the Nikkei peaked in Dec-89, the market has fallen 80%, nearly 8% per year 400 350 300 250 200 150 100 50 0 AMI Investment Management *Data through March 17, 2009; Source: Yahoo
  43. 43. Japanese Price-to-Peak Earnings US peaked at approximately 33.0x in 2000 AMI Investment Management *Source: John Hussman
  44. 44. Japanese GDP Growth AMI Investment Management *Source: US Treasury
  45. 45. Swedish Approach Comprehensive guarantees of depositors/foreign counterparties “Bank Support Authority” – arm’s length organization designed to monitor process Strategy for testing banks was developed and explained – if worst case stress test deemed a bank insolvent, bank was closed or merged in an orderly manner Banks were forced to write down bad loans Split into a “good bank/bad bank”, managed by AMC (RTC) Strict valuation rules remained in effect Govt did not take any specific measures to save non-financial institutions and did not instruct banks on how to use money Equity and debt holders were forced to share pain AMI Investment Management *Source: Lars Heikensten
  46. 46. Japanese banks became heavily invested in loans backed by real estate as collateral, as real estate prices soared. When the turn came and prices cascaded downward, the collateral became inadequate. But instead of calling the loans, as most Western banks would do, the bankers refrained. It took years and many government bailouts before real estate prices stabilized and the banking system returned to normal lending, with realistic estimates of bad loans and, hence, capital… There is no doubt in my mind today, as then, that an RTC-like strategy invoked during the period of Japanese economic stagnation, from 1990 to 2005, would have shortened the period of adjustment and returned Japan to a normally functioning economy years sooner… What was the invisible economic force holding Japan back?...The missing force was not economic; it was cultural. The Japanese had purposely accepted hugely expensive economic stagnation to avoid a massive loss of face for many companies and individuals. I cannot imagine U.S. economic policy following such a track. - Alan Greenspan in The Age of Turbulence AMI Investment Management
  47. 47. Japanese Approach Continued to allow lax acctg standards and tolerant approach to bank valuation; banks were not forced to recognize losses Govt support was not conditional on improved risk management practices; excessive risk-taking continued Banks sat on bad debt, hoped situation would turn around; “zombie companies” lingered on 10 years after initial crisis, govt focused on full disclosure and improved practices – prompted a wave of write-offs BoJ slow to cut rates (17 months); did not reach 0.5% until mid-90’s; deflation worries persisted Resolution and Correction Corporation formed in 1999 to dispose of bad loans The govt DID throw a lot of money at the problem AMI Investment Management
  48. 48. Resolution Formula (US?) Prevent immediate crisis resulting from panic by issuing guarantees and protecting the banking system (yes) Set-up a transparent process and independent organization to implement policies (maybe) Develop a rigorous approach to identify bad banks (maybe) Segregate “good bank” from “bad bank”; recapitalize good bank, transfer bad assets to AMC (not yet) Remain firm on accounting rules (so far) Force equity and debt holders to share pain (not really) AMI Investment Management
  49. 49. Institutions that cannot survive without continual provision of public funds should be taken into receivership, their assets should be restructured to better ensure repayment, their stockholders should be wiped out, bondholders should take a major haircut, customer assets should (and will) be fully protected, and these institutions should be re-issued to the markets when the economy stabilizes… Unless Congress is actually willing to commit that amount of public funds to defend the bondholders of mismanaged financials so they can avoid any loss, this crisis simply cannot be addressed through bailouts. Bondholders have to take losses. Debt has to be restructured (and can be restructured in ways that largely preserve the present value of the obligations). There is no other option – but the markets are going to suffer interminably until our leaders figure that out… Why should the American public (and eventually our children) foot the bill to protect the full interests of corporate bondholders? Has everybody gone completely insane, or is it simply not clear that the sum total of the government's response to- date has been to squander public funds to defend private bondholders? - John Hussman in Weekly Market Comment AMI Investment Management
  50. 50. The Situation Before the Crisis: Good Assets 90 Deposits 80 Bad Assets 10 Debt to Bondholders 17 Shareholder's Equity 3 Total Assets 100 Total Liabilities and Equities 100 After the Crisis: Good Assets 90 Deposits 80 Bad Assets 5 Debt to Bondholders 17 Shareholder's Equity -2 Total Assets 95 Total Liabilities and Equities 95 AMI Investment Management
  51. 51. Equity is effectively a “call option” on company AMI Investment Management *Source: JP Morgan
  52. 52. Government Proposals Govt Buys Troubled Assets: Good Assets 90 Deposits 80 Proceeds From Sale to Govt 5 Debt to Bondholders 17 Shareholder's Equity -2 Total Assets 95 Total Liabilities and Equities 95 Govt Provides Capital Junior to Debtholders: Good Assets 90 Deposits 80 Bad Assets 5 Debt to Bondholders 17 Proceeds from Govt Infusion 5 Govt Pfd Equity 3 Shareholder's Equity 0 Total Assets 100 Total Liabilities and Equities 100 AMI Investment Management
  53. 53. Alternative Approaches Govt Provides Capital Senior to Debtholders: Good Assets 90 Deposits 80 Bad Assets 5 Govt quot;Super-bondquot; 5 Proceeds from Govt Infusion 5 Debt to Bondholders 15 Shareholder's Equity 0 Total Assets 100 Total Liabilities and Equities 100 Good Bank: Good Assets 90 Deposits 80 Bad Assets 0 Debt to Bondholders* 10 Proceeds from Govt Infusion 5 Govt Equity* 5 Proceeds from Private Infusion 5 New Shareholder's Equity 5 Total Assets 100 Total Liabilities and Equities 100 *Govt organization proceeds with monetization of bad assets; proceeds accrue to govt, bondholders AMI Investment Management
  54. 54. We're setting the stage for when we come out of this of a massive inflation holocaust. -Famed Investor Jim Rogers on CNBC Economic medicine that was previously meted out by the cupful has recently been dispensed by the barrel. These once-unthinkable dosages will almost certainly bring on unwelcome aftereffects. Their precise nature is anyone’s guess, though one likely consequence is an onslaught of inflation. Moreover, major industries have become dependent on Federal assistance, and they will be followed by cities and states bearing mind-boggling requests. Weaning these entities from the public teat will be a political challenge. They won’t leave willingly. Whatever the downsides may be, strong and immediate action by government was essential last year if the financial system was to avoid a total breakdown. - Warren Buffett in the 2008 Berkshire Hathaway Annual Report AMI Investment Management
  55. 55. Government spending and inflation… AMI Investment Management *Source: John Hussman
  56. 56. What are the risks? Federal Reserve will struggle to contain inflation (deflation is current threat) Currently not an issue because of the depressed multiplier Massive government borrowing shifts bad debt from corporate balance sheets to public balance sheets, where it can only be serviced through increased taxes or inflation Government borrowing may “crowd out” private borrowing, force up long-term interest rates Will Japan, China and the rest of the world continue to finance the US government? (20%/50%) The risk of inflation and steep government debt may pressure the US dollar Is it logical to approach our current economic problem, created by the over- use of debt, by employing more debt? What does a de-leveraged American economy look like? What kind of system will we create? More governmental regulation and intervention; private sector reliance on the state? AMI Investment Management
  57. 57. First of all, banks and investment banks and insurance companies have been failing for hundreds of years. Yes, we would've had a terrible two years. But you're dragging out the pain. We had 10 years of the worst credit excesses in world history. You don't wipe out something like that in six months or a year by saying: quot;Oh, now let's wake up and start over again.quot; They should be allowed to go bankrupt. Why should American taxpayers put up billions to save a few car companies? They made the mistakes! We didn't make the mistakes! I'm sure they'll give them the money, but I'm telling you, it's a mistake. It's a horrible mistake. - Famed Investor Jim Rogers in BusinessWeek AMI Investment Management
  58. 58. And it is not only households…it is firms, states, municipalities and the federal government AMI Investment Management *Source: Advisor Intelligence
  59. 59. AMI Investment Management *Source: Advisor Intelligence
  60. 60. AMI Investment Management *Source: GAO (2008)
  61. 61. AMI Investment Management *Source: GAO (2007)
  62. 62. How do we prevent a repeat? Guard against assymetric payoffs Eliminate moral hazard Attempt to improve transparency so that investors, counterparties and regulators can evaluate firm risk Centrally regulate derivative markets Understand the limitations of models and the existence of “black swans” Remove political pressures on consumption Still, free markets are always susceptible to financial crisis brought on by debt, exuberance and often times financial innovation AMI Investment Management
  63. 63. [C] Thoughts on the Stock Market and Portfolio Management A Perspective on the Current Economic Crisis | March 2009
  64. 64. Managing a Portfolio in Today’s Environment Is the US stock market fairly valued? Will it go lower? Diversification and Modern Portfolio Theory What risks must the investor guard against? AMI Investment Management
  65. 65. The PE Multiple Price Earnings For $X, how many dollars of earnings can I purchase? Easy to measure price, but how do we measure earnings? TTM, Forward, full cycle, peak… Perhaps necessary to evaluate other market valuation measures AMI Investment Management
  66. 66. S&P 500 TTM PE 50 45 40 35 30 25 20 15 10 5 0 TTM PE Average AMI Investment Management *Data through March 17, 2009; Source: Robert Shiller
  67. 67. Forward P/E Duration Price Forward P/E Proj. Earnings Peak Trough in Years Decline Peak Trough $40 $64 Sep-29 Jun-32 2.8 86% 22.0 10.7 428 685 Mar-37 Apr-42 5.1 60% 28.1 13.4 536 858 May-46 Jun-49 3.1 30% 33.6 10.7 428 685 Aug-56 Oct-57 1.2 22% 26.9 24.5 980 1,568 Dec-61 Jun-62 0.5 28% 38.5 26.3 1,052 1,683 Feb-66 Oct-66 0.7 22% 31.4 25.3 1,012 1,619 Nov-68 May-70 1.5 36% 31.7 21.9 876 1,402 Jan-73 Oct-74 1.7 48% 22.8 11.3 452 723 Nov-80 Aug-82 1.7 27% 10.9 8.5 340 544 Aug-87 Dec-87 0.3 34% 18.0 10.3 412 659 Jul-90 Oct-90 0.3 20% 16.9 14.4 576 922 Mar-00 Oct-02 2.6 49% 26.9 15.9 636 1,018 Average 1.8 39% 25.6 16.1 644 1,030 Median 1.6 32% 26.9 13.9 556 890 Best 0.3 20% 10.9 26.3 1,052 1,683 Worst 5.1 86% 38.5 8.5 340 544 Current Bear Market: Oct-07 Mar-09 1.4 50% 22.4 10.6 AMI Investment Management *Data through March 17, 2009; Source: Barron’s
  68. 68. Shiller Real P/E Ratio - Real Price/Real Trailing 10-yr Earnings 50.0 Percentile: 36.26% 45.0 Average P/E(10): 16.34 Current P/E(10): 13.57 40.0 If P/E(10) = 7.50 - 10.00… 35.0 S&P 500 = 430 – 575 30.0 25.0 20.0 15.0 10.0 5.0 0.0 P/E(10) Current Average AMI Investment Management *Data through March 17, 2009; Source: Robert Shiller
  69. 69. 40th Percentile 50th Percentile AMI Investment Management *Source: William Hester, March 2009
  70. 70. 1881-1999 22.00% 21.00% 20.00% 19.00% 18.00% 17.00% 16.00% 15.00% 14.00% Next 10-yr Total Return 13.00% 12.00% y = -0.0049x + 0.168 11.00% R² = 0.2909 10.00% 9.00% Series1 8.00% yr Linear (Series1) 7.00% 6.00% 5.00% 4.00% 3.00% 2.00% 1.00% 0.00% -1.00%0.00 5.00 10.00 15.00 20.00 25.00 30.00 35.00 40.00 45.00 -2.00% -3.00% -4.00% -5.00% Shiller's Trailing 10-year Real P/E Ratio AMI Investment Management *Data through March 17, 2009; Source: Robert Shiller
  71. 71. 1950-1999 21.00% 20.00% 19.00% 18.00% 17.00% 16.00% 15.00% 14.00% Next 10-yr Total Return 13.00% 12.00% y = -0.0057x + 0.2045 11.00% R² = 0.5751 10.00% 9.00% Series1 8.00% 7.00% yr Linear (Series1) 6.00% 5.00% 4.00% 3.00% 2.00% 1.00% 0.00% -1.00%0.00 5.00 10.00 15.00 20.00 25.00 30.00 35.00 40.00 45.00 -2.00% -3.00% -4.00% -5.00% Shiller's Trailing 10-year Real P/E Ratio AMI Investment Management *Data through March 17, 2009; Source: Robert Shiller
  72. 72. EPS Growth Since 1951 - Logarithmic Scale 100.00 EPS growth has consistently averaged 6% per year y = 1.9928e0.058x R² = 0.954 10.00 EPS Expon. (EPS) 1.00 AMI Investment Management *Source: Robert Shiller
  73. 73. Hussman Model for Predicting 10-yr Equity Total Returns 25.00% P/E = 7 - 5.41% P/E = 11 - 8.93% P/E = 14 - 11.07% 20.00% P/E = 20 - 14.52% 15.00% 10.00% 5.00% 0.00% -5.00% -10.00% P/E = 7 P/E = 11 P/E = 14 P/E = 20 Actual AMI Investment Management *Data through March 17, 2009; Source: Robert Shiller, John Hussman
  74. 74. Grantham/GMO 7-yr Asset Class Real Return Forecasts - Feb-09 Assumes Infl = 2.5% 16.0% 2.3% 1.8% 3.7% 14.0% 2.3% 12.7% 12.7% 12.0% 10.8% 1.8% 1.8% 10.7% 10.0% 8.9% 8.9% 2.9% 8.0% 1.5% 6.0% 6.0% 5.7% 4.0% 2.4% 2.0% 1.8% 1.6% 0.9% 0.9% -0.5% 0.5% 0.0% 0.2% US Large US Small US High Intl Large Intl Small Emerging US Govt Intl Govt Emerging Inflation ST US Managed Cap Equities Cap Equities Quality Cap Equities Cap Equities Market Bonds Bonds Market Indexed Treasuries Timber Equities Bonds Bonds -2.0% Real Return With Active Mgmt AMI Investment Management *Source: GMO
  75. 75. 60th Percentile 70th Percentile AMI Investment Management *Source: William Hester, March 2009
  76. 76. MPT and Diversification Diversification is meant to reduce portfolio risk without sacrificing return Unfortunately, during times of financial crisis, asset classes become much more correlated AMI Investment Management *Source: Wikipedia
  77. 77. What Happened to Diversification? 2008 # Asset Class 31-Dec-07 31-Dec-08 Return ETF 1 Long-term US Govt Bonds 93.04 119.35 28% TLT 2 High Grade Corporate Bonds 104.84 101.65 -3% LQD 3 High Yield Corporate Bond 100.72 76.01 -25% HYG 4 Preferred Equity 41.50 29.21 -30% PFF 5 Large-Cap Equity 132.55 87.52 -34% DIA 6 Mid-Cap Equity 84.94 53.33 -37% IJH 7 Small-Cap Equity 75.90 49.24 -35% IWM 8 International Equity 78.50 44.86 -43% EFA 9 Emerging Markets Equity 50.05 24.97 -50% EEM 10 US Real Estate 79.14 44.18 -44% ICF 11 Gold 82.46 86.52 5% GLD 12 Commodities 56.23 35.19 -37% DJP AMI Investment Management *Source: Yahoo
  78. 78. 2008 Nominal Asset Class Returns (Price Only) 40% 30% 20% 10% 0% 1 2 3 4 5 6 7 8 9 10 11 12 -10% -20% -30% -40% -50% -60% AMI Investment Management *Source: Yahoo
  79. 79. Digging Deeper into Corporate Bonds… AMI Investment Management *Source: Yahoo
  80. 80. Is Diversification a Fraud? Diversification is an important tool in portfolio management However, it is a tool to be carefully applied; while “rules of thumb” may help some investors, a more careful analysis may be warranted MPT optimization must take account of valuation levels and forecasted volatility, as well the investor’s situation, risk tolerance, goals and timeframe Perhaps employ black swan events in analysis MPT is more robust if truly uncorrelated asset classes are included The case for alternative assets AMI Investment Management
  81. 81. Portfolio Risks Inflation – investors must guard against the damage that inflation can wreak on a portfolio Stock market volatility and uncertainty The 1990’s are likely not the norm Depressed valuations look to reward investors with good returns, but there remains risk to the downside (DCA) The de-leveraging cycle is necessary, and it is unclear just how large of an impact this will have on consumers and firms Delaying this process does not make it go away AMI Investment Management
  82. 82. Amid this bad news, however, never forget that our country has faced far worse travails in the past. In the 20th Century alone, we dealt with two great wars (one of which we initially appeared to be losing); a dozen or so panics and recessions; virulent inflation that led to a 21.5% prime rate in 1980; and the Great Depression of the 1930s, when unemployment ranged between 15% and 25% for many years. America has had no shortage of challenges. Without fail, however, we’ve overcome them. In the face of those obstacles – and many others – the real standard of living for Americans improved nearly seven-fold during the 1900s, while the Dow Jones Industrials rose from 66 to 11,497. Compare the record of this period with the dozens of centuries during which humans secured only tiny gains, if any, in how they lived. Though the path has not been smooth, our economic system has worked extraordinarily well over time. It has unleashed human potential as no other system has, and it will continue to do so. America’s best days lie ahead. - Warren Buffett in the 2008 Berkshire Hathaway Annual Report AMI Investment Management
  83. 83. About AMI Investment Management AMI Investment Management is an independent registered investment advisor. Established in 1995, AMI utilizes fundamental research and analysis in managing equity, fixed income and alternative investment portfolios for individuals and institutions. Our mission is to protect and enhance the purchasing power of our clients’ assets. Contact: 260.347.1281 AMI Investment Management