Evergreen Virtual Advisor – Investment Newsletter by David Hay

Past EVAs have noted that the trailing 10-year return on the stock market now trails that of the 1930 to 1939 period. As you can see from the chart below, the last decade is now essentially tied with the fourth worst 10-year period going all the way back to the 1830s.

Points to Ponder

Foreign markets have also been decimated; in Japan, the Nikkei 225 is trading at its lowest price/earnings ratio since the early 1970s, with 84% of the Japanese blue chip index trading below book value.

Similar to what’s occurred in the corporate bond market, yields on tax-free bonds have also surged. Long-term municipal bonds now yield 6.7%, according to Merrill Lynch, up from 5.44% a month ago.

Inflation is retreating at an astonishing rate. A key measure of the Producer Price Index fell 9.4% in September alone, a record decline for one month.

Earlier this year, the primary driver of rising inflation was oil; now, energy is the key factor pushing it down, and that may intensify as OPEC brings on new production of three million barrels per day. Consequently, the cartel is frantically seeking to cut output quotas but, based on past history, widespread cheating occurs during periods of falling prices

Precious and industrial metals have also been crushed of late, as have the stocks in the companies that extract them. As you can see in the chart on the right, the World Mining Index is down 60% and is still falling.

EVAluating the Environment

It’s an ill wind … As many of you know, these last seven weeks or so have been particularly excruciating for me because almost all of the income investments we hold for clients have been crushed. These normally defensive instruments were, for a time, falling further and faster than the stock market itself. Even high-grade corporate bonds succumbed, at one point falling a jaw-dropping 20% in a few weeks. Naturally, this traumatized most of us who felt we had the hatches pretty well battened down for the tempest. The fact that we’ve gone through something far beyond the perfect storm—more like a Force 5 hurricane that just keeps circling back on top of us—only aggravated matters. But if we can overlook the temporary price declines, the long-lasting positive is that this unparalleled convulsion gives us a chance to buy more of these securities at yield levels associated with bouts of high inflation. Looking back, it’s very clear when this yield moon shot began its liftoff.

Another day for the history books. The ability to lock in 9% and 10% (or even higher) at a time when inflation is imploding has never happened in my nearly 30-year career. In fact, when I review the history of the financial markets, I don’t believe it’s ever occurred. Even during the worst days of the Great Depression, 1932 and 1933, high-grade corporate bonds fell in aggregate by 10% to 15% before quickly recovering. As mentioned in earlier EVAs, the recent unprecedented decline in yield instruments was due to the fact that they were the first victims of forced liquidation by leveraged institutions. The most brutal phase of this began on September 7, 2008, another day that will live in infamy, when Fannie Mae and Freddie Mac were essentially confiscated by the federal government. Like a previous infamous day, it was also a Sunday; when the markets opened on Monday, the London interbank lending rate (Libor) started to explode, as did all private-sector interest rates.

The home buyer of last resort, too? Because the last EVA was devoted to my belief that there is an acute need for government intervention to normalize credit spreads, I’m going to refrain from much detail this time (for those of you who missed it, my proposal is for the government to purchase massive amounts of very depressed but high-grade corporate debt). But it’s reasonable to ask: Why shouldn’t the government also start buying up homes around the country to prop up their prices? After all, wasn’t it falling home price values that got us into this morbid mess in the first place? Undoubtedly, housing prices have cratered in a way also unmatched since the 1930s; thus, it would seem to make superficial sense that the government should buy up excess supply to stabilize that market. Unfortunately, there are several major problems with this potential solution.

The trouble with housing. First, there is no central marketplace for homes, as there is for corporate debt and preferred stocks. Second, by almost all measures I look at, home prices are still above normal. Third, unlike bonds, investing in housing provides little if any net cash flow above carrying costs; therefore, the cost of this to the government would be immense at a time when deficits are already soaring. In contrast, by acquiring corporate bonds and preferred stocks at a time of extraordinary private-sector interest rates, the government would be doing what all the rest of us should: locking in great yields while they last. On a $500 billion investment (note: not an expenditure), the government would be able to net at least $30 billion per year (a conservative estimate between its cost of capital and current prevailing high-grade bond interest rates). As previously noted, the government would also be almost assured of capital gains once investors regain confidence and start buying corporate securities again. But just because government purchases of homes may not be a good idea, there still are other viable solutions.

Outside my small circle of competence. Let me concede right now that I’m pretty much clueless when it comes to how to deal with the housing debacle. However, there are some encouraging measures that have already been put in place, such as offering first-time home buyers a $7,500 tax credit that is repayable through a higher tax payment over 15 years. Basically, this is an interest-free loan to (primarily) the echo baby boomers, re-paid in $500 annual installments. Our youngest son will almost certainly be taking advantage of this before it expires next summer (for those of you with children or grandchildren ready to become homeowners, you should be aware of this). With regard to more advanced triage for the housing market, there is an investment banker (yes, some of them actually have a heart) named Bill Alpert who was the subject of a recent NY Times article. He’s advocating that lenders allow troubled homeowners to become renters, lowering their payments to prevailing lease levels. Then in five years they would have the option of buying their house back at fair market value. Something along these lines seems plausible to me, but now back to my sandbox…

Dateline: 1974. It was 34 years ago that Warren Buffett was famously quoted in Fortune magazine as saying there were so many irresistible bargains in the stock market that he felt like a high testosterone guy in a harem (actually, his comment was a bit more Rrated). In Evergreen Capital Management’s most recent quarterly newsletter, The Strategist (sent only to ECM clients), I drew a number of parallels between the current market environment and that of 1974. Thus, it’s appropriate that the Oracle of Omaha recently penned an op ed piece in the New York Times declaring that for the first time in many years he’s buying US stocks. Intriguingly, he was referring to his personal account and not that of his fabled company, Berkshire Hathaway. According to this piece, he has personally owned only government bonds for years, something I was not aware of, especially since he often sings the praises of companies Berkshire owns, like American Express and Wells Fargo. Also interesting was the relatively tepid response his rare public display of enthusiasm generated. Perhaps such apathy is even more bullish than Mr. Buffett’s buying spree.

Blindfold investing. It was just a couple of weeks ago that there was a major chasm between the valuation of regular common stocks and the income securities mentioned above. Essentially, the stock market was merely pricing in a light recession while yield vehicles were discounting the end of civilization as we know it. Lately, however, stocks have cratered at the same time that preferreds and the publicly traded partnerships have rallied, in some cases 20% to 30% (nevertheless, they remain exceedingly depressed). Consequently, it’s now a situation where virtually everything but Treasuries is being given away (even tax-free bonds). I’ve told a number of clients that you can throw a dart and make a bunch of money—if you have the courage to throw the dart. The problem is almost no one does—even when informed that Buffett is launching a few of his own. As far as I’m concerned, all I need to know is that almost all investors are terrified, stocks are clearly undervalued, and Buffett is buying. Please pass the darts.

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