back to blog homepage

A Must Read Analysis from Doug Kass

Doug Kass published the following article today. It sums up the current state of our economy and the investment markets much better than the RBS economic crash analysis from last week.

We continue to monitor our stop loss orders, and if we get a short-term bounce in the stock market that Doug forecasts, we will raise them accordingly to protect those gains.

mb

The Loss of (Investment) Innocence
6/23/2008 7:39 AM EDT

We now face the aftermath of a bygone credit cycle gone ballistic.

“I used to be Snow White — but I drifted.”

— Mae West

It’s innocence when it charms us, ignorance when it doesn’t.

For over two decades, with the possible exception of the aftermath of the speculative bubble of the late 1990s, equity investors have been comforted by the notion that nearly every dip has been a buying opportunity as the U.S. economy has typically recovered relatively swiftly from economic and credit, geopolitical, systemic and assorted exogenous shocks. And for over two decades, fixed-income investors have been comforted by the tailwind of disinflationary influences, which provided excellent absolute and relative returns in bonds.

Stated simply — similar to Edith Wharton’s brilliant The Age of Innocence, when “being was better than doing” — stocks and bonds were no-brainers to most. After all, investors’ intermediate- to longer-term experiences in the capital markets were universally solid.

The media insisted that investors buy stocks and bonds for the long run as the sky was the limit. Even James Glassman and Kevin Hassett’s Dow 36,000: The New Strategy for Profiting From the Coming Rise in the Stock Market seemed within reach.

“Here’s another fine mess you have gotten me into.”

— Ollie (Laurel and Hardy)

As we entered the New Millennium, the U.S.’s economic moorings became unanchored as unprecedented low levels of interest rates produced a second wave of speculation in housing and daytrading in homes replaced the daytrading in stocks. The generous availability of low-cost capital and debt formed the foundation of an unprecedented boom in consumer borrowing, a massive spending binge and a desperate institutional search for yields.

A shadow banking industry emerged as the helter skelter move into derivative products (which were unregulated, unwieldy and intentionally seemed to circumvent banking capital requirements) rapidly materialized. And an eager hedge fund community joined the happy hour of leveraging while unquestioning investors seemed to sanction the generation of common returns that were produced by taking uncommon risks.

At the epicenter of the leverage was the housing market, which was confidently embraced by owner non-occupied investors, who stretched housing prices and affordability (home prices divided by household incomes) to unsustainable levels. Expectations of a long, uninterrupted boom in residential real estate became the newest paradigm.

Generally speaking, the availability of cheap credit made the notion of debt more acceptable and institutionalized leverage, serving to enrich a small cabal of originators who sliced and diced housing mortgage products. With the benefit of hindsight, however, it is clear that the mass marketing of debt began to poison the world’s financial system.

“All for one! One for all! Every man for himself!”

The Three Stooges, “Restless Knights” (1935)

That was then and this is now.

Last week, we saw a tsunami of selling, which was in marked contrast to my expectations for some stability.

We now face the aftermath of a bygone credit cycle gone ballistic. The world’s financial system is, to some important degree, crippled and in a workout mode now. In all likelihood, the pendulum of credit will swing to an opposite extreme, and availability (the lifeblood of economic growth) will become dear, which is in marked contrast to the freewheeling decade of the past.

Regardless of short-term direction, we continue to be in an investing environment that argues in favor of erring on the side of conservatism. Most should maintain smaller-than-typical investing/trading positions and should keep conviction on the back burner.

The experience of the last 12 months has exacted a toll on investors. Household net worths have taken a hit from the depreciation in stock and home values, confidence in our politicians and corporations (especially of a financial kind) have rarely been lower, and, importantly, investors’ innocence has been lost.

While, at some point (maybe sooner than later), the equity markets will rally from the current oversold readings, an extended period of investor disinterest and apathy seems likely to follow.