Rational Advisor

These two artists recently made a neat poster

http://www.tate.org.uk/tateetc/issue8/fischliweiss_workingitout.htm

Here’s the key points on working better

1. Do one thing at a time
2. Know the problem
3. Learn to listen
4. Learn to ask questions
5. distinguish sense from nonsense
6. Accept change as inevitable
7. Admit mistakes
8. Say it simple
9. Be calm
10. Smile

For these markets, maybe we can repeat points 5 and 9

Let me take you back to some comments from the BUSH TV (or should we call it MADTV)

- The Nations is in dire trouble, if we do not act
- We have some serious problems
- This will affect us all
- We need to implement this plan as soon as possible
- Our specialists have done the research and told us that it is nto good.
- You can trust in us

Uhmmm… that was in September 2002 (the last time Bush came up and asked for such large funding) and the issue then was Saddam and the WMD’s that they had research on.

The world and the US people believed Bush then, that if they did not act, the bombs would fly right into their own homes. The story told to the world was terrible.

They went forward and got the money to implement their plans, and the follow through was sheer misery, for the Iraqi people, for the US people, for the world, for global economics

And now we get the same show, but it’s related to the Financial crisis - these WMD’s called mortgages!

I believe that even though this $700B will get through - it is a similar thing. Their research is not upto scratch - let companies that did wrong fail - let economic darwinism work - strong shall inherit over the meek. In this case the JP Morgans, goldman Sachs, RBC’s, TD’s and Wells Fargos shall inherit and swallow over the Lehman’s, WaMu’s etc.

I believe the long tun implications for $700B of extra liquidity, is artificial

I repeat Milton Friedmans’s quote. “Whenever their is a government solution to a problem, the solution is usually worse”

“it’s not the employer who pays wages. he only handles the money, it’s the product that pays” - Henry Ford

I think Henry got it right, too many times we don’t think about the product and services we have. The better explained and managed the product, the better the service, the better the pay.

it’s just that simple, but still so hard to do.

Take a look at Ford - they forgot the key thing, that it was the product, and instead let competition get ahead of them, with better product, and then service suffered - and now we have the classic story of the fall of Ford.

Here it is, after all that research mythoughts on the next ten years

- Inflation in Canada averaging 10.3%
- 90 day Government of Canada T-Bills averaging 10.3%
- An Assissanation attempt on a US presdent
- A series of major stock exchaneg scandals
- A stock market crash of 1929 proportions
- A disintegration of a major world power

Yep, these headlines are all from the 1980’s - a period during which the average annual return for the TSX averaged 12.2%. So much for the relationship between headlines and stock prices

(note - source statistics Canada, and also past returns arenot indicative of future results)

This was a crazy week, but pretty much all of our ducks are in a row here.

I blame much of the recent volatility on regulators who removed the “up tick” rule for short selling. This meant that you could not short sell a stock till you had an up tick in its price. Because of the elimination of this rule, people can put a lot of momentum and drive down otherwise sound companies, and not give them space to breathe. The SEC has bee remiss in their responsibilities - right now the risks have been higher and the returns static - this is not the norm!

In 1999, The Glass-Seagal rule was removed. And banks were allowed to become less regulated and engage in higher risk businesses. So, yes I do blame the regulators for allowing the current problems. Imagine what would happen if all of a sudden you relaxed the rules on your children. Now, they can have all the drugs they want, they can shoot whoever they want, they can get into all the trouble they want.

Some good news, on Thursday Sept 18th, the Bank of Canada held crisis talks with the CEOs of Canada’s largest banks. They discussed the ongoing stress levels in inter-bank lending and contingency measures. This happened as major central banks injected some $180 Billion of additional liquidity into financial markets worldwide.

There’s some belief that there is more relief to come from the US Feds and that the smoke is finally clearing. We may be getting better visibility but we are still in the midst of this wreck. Yes, the US Fed is attempting to resurrect confidence. However, regaining confidence takes time. The largest brokerage and investment banking firms in the words business models are being questioned.

What we have is a lack of confidence, a lack of cheap funding to a leveraged balance sheet. In reality this wills till take some time.

The US Federal reserve even took the extraordinary step of providing the Bank of Canada and other countries with billions of dollars each. The money is meant for domestic commercial banks desperately seeking short term loans of dollars. The Bank of Canada made some $10 Billion liquidity available to Canadian banks

Short sellers that were blamed for the recent market meltdown are now under fire.

The US congressional aids have been saying that the SEC approached law makers last night about a plan to temporarily halt short selling. Earlier the UK Financial Services authority banned new short selling of Financial services stocks effective Friday Sept 19.

New York Attorney Andrew General Cuomo has called on Financial Regulators to freeze short selling of financial stocks in the US too.

This will hurt hedge funds even more. But will provide some level of sport to the markets. It will also impact commodities negatively, as the US dollar begins to appreciate.

Most commercial banks still have strong franchises and good businesses, especially the Canadian banks. The problem is that the collapse of share prices reinforced by short selling particularly by hedge funds is only leading to more and more concern and a lack of reality to more of a fear factor than the reality of strength of these banks. I just hope the fear factor disappears because these banks that exist today are good franchises and are generally quite strong businesses and should still be in existence a year from now, a decade from now. I can see the banks taking advantage of this government liquidity and use the proceeds to buy back their own debt, shoring up their balance sheets and investor confidence in their survivability.

The markets hate uncertainty. But one thing that is a quick certainty is that the current US president is talking about wanting to do everything to help and both US presidential candidates are asking for better regulation. We can expect something to happen within the first 100 days of the new administration.

The future means a repair to the global economy and markets rebounding, but you will have to still have some patience.

Some of the positive trends that need to be considered are
- We are seeing a fall in inflation globally
- We are seeing interest rates falling globally
- We can expect global governments to cut taxes and increase spending

All these are supportative of growth.

So, yes, we’ve got a lot of bad news at the moment, but I think the next few months we could also see in a sense the medicine for this sick patient, which is provided s with a low point for the markets.

I encourage you to not get too emotional, not get too panicky of what you are seeing. I do think the prices are right, I just don’t know if there is any perfect timing.

If someone were to say to me, “where will we be in five years?” I believe you’d see a substantial return from current levels, but we could see lower targets for the markets over the next 3 months. In my mind we may be at the end of the bear market for common stocks and the even severe bear market for financials. To me this may be the equivalent to buying stocks after the crash of 1987.

Sadly, it’s always the case that the best opportunities are at times when you see commentators talking up the negative stories - that’s the environment we are in currently. You have to be brave, and you’ll typically be right.

“When will market cycles be banished or made muted? That’ll happen when greed, human failings and herd behaviour are eliminated. Or, in other words, never” - Howard Marks, Manager of the Oaktree Fund

What we are hearing is a lot of news about bank failures, Lehman Bros, Marrill Lynch etc.

Let’s take a look at some US History on Bank Failures and what happened to the markets.

Go back to the the mid 1970’s when Tricky Dicky, Richard Nixon was resigning as presiident of the USA, and we had Vietnam, Watergate. In the mioddle of all of this a Bank called Franklin National Bank failed. Soon after the failure the markets rose.

In the early 1980’s, gold shot up to $800 and a recession ensued. then a bank called Penn Square bank failed, followed by Continental Illinois Bank, subsequent to that we got one of the strongest rallies in the markets - the media was saying “The Death of Equities” - Business Week, the US is broke! But surprisingly things worked out.

In 1988, we got the failure of the First Republic Bank. The government stepped in created Resolution Trust and once again the markets rallied.

In 1991, there was the Savings and Loans crisis, and bank problems were worse, much worse than now, and we saw the failure of the Bank of New England. The resultion of this led to a significant rally.

So, similar to today, the act of Bank Failures (which surprisingly mostly happened in July’s) and the act of resolving these were indications of the bottoms of those markets.

We are possibly there

When Hank Paulson and his cronies in the US Treasury Dept unveiled their bizarre rescue and seize of control of government sponsored entities (GSEs) - Fannie and Freddie. I got worried and thought that the was all some kind of horror story concoted by Stephen King. I don’t believe that Freddie and Fannie were in that large a trouble. yes, they held bad mortgages , but they also held good mortgages. To me, this stunk of the worst kind of politics being played. Note - Fannie and Freddie were created by democrats - the current regime is Republican.

In reality, Fannie and Freddie are not being nationalized as many people believe, boththe common and preferred shares will continue to trade. What the government is doing is taking warrents (basically long term options) on Fannie and Freddies share price, but it’s doing it like Mafia loan sharks. Rather than getting warrants for 20% to 30% of the company, their grabbing an 80% equity stake.

So, these guys in the future will get 80% of Fannie and Freddie IF they exercise the options - otherwise they’ll just make money on the recovery. Meanwhile, investors have bid down the price of Fanniie and Freddie, thinking it’s already taken over - I smell a law suit somewhere.

The government should have been more cleare on what they are getting at Fannie and Freddie.

As economist Milton Friedman said “The government solution to a problem is usually as bad as the problem”

One logical question is: “how bad is it?” In stock market history, has it been this bad before? When, and what were the circumstances? Has it been worse? Have we reached a turning point in the credit crisis with the bankruptcy of Lehman or is this just the start of worst times to come?

And finally, what about my investments?

Hopefully we’ll get through al lot of these

But let’s take the last one first.

Be grateful you have Bonds, this is one of the key reasons I always say Bonds are a great investment to have in your portfolios. They are a source of comfort in stormy weather. With their income streams and their government guarantees. And we have a lot of Bonds.

Now about the stuff that’s not in Bonds – the Equities. Most of these are in large companies that are excellent businesses with good balance sheets, lots of cash in their pockets, and good potential for future growth. However, being part of the equity markets, they will also be impacted.

No, we didn’t hold any Lehman Bros, Merrill Lynch or AIG. What we did hold were the sounder well managed banks – Bank of America, JP Morgan and the Canadian Banks. Due to people’s fears about these companies and what will happen to them, they also have been caught up in the perception of doom. There’s nothing wrong with these banks, they continue to make good revenues. As long as you keep visiting your banks, depositing your cheque, paying your mortgage, bills, using your credit cards and paying your monthly service fees – everything will be fine.

That’s not to say that strange things can’t happen to good companies. We believe Fannie and Freddie were excellent businesses that repackaged US mortgages and had the governments guarantee in case of failure. They were the middle men. The US government wasn’t getting paid for providing this guarantee. By taking over Fannie and Freddie they now get paid for it. So, yes strange things do happen to good companies. So, we won’t always be immune.

Yes we are impacted by the perception of doom, but the reality is that our investments are still making good revenues. Eventuality reality triumphs over perception. It just may take some time for reality to rear it’s head, as the sellers of doom – the media, get to realize their mistake.

We’ve been here before; we know how this movie ends. The cast of characters is different. In the past they were E.F. Hutton, Drexel Burnham Lambert, Salomon Brothers, and Prudential. Securities. Today’s it’s Bear Stearns, Lehman Brothers and Merrill Lynch. .

Realize that this is what happens, Bad loans are made in good times, and firms do get into trouble when times are not good anymore.

Two investment banks have disappeared from the scene - but in reality none of these were commercial banks, and neither is AIG an investment bank or a commercial bank.

There has been a huge blurring of the line between investment banks and commercial banks. Remember investment banking is a cyclical industry, when they are hot they are hot, when not, they are not.

Who brought is to this situation today, many fingers can point to the Feds and the SEC, who put a blind eye to investment bank lending activities, and wasn’t watching what the these investment banks were doing, and felt that the products that were being produced were fine to be traded without transparency.

The culture of safety and soundness had gone from these banks.

You have to bring back transparency. The products we are talking about, derivatives are not inherently bad. In fact, they are inherently good.

But the misuse of these products just like the misuse of an explosive like dynamite is certainly bad.

And we are experiencing the misuse of these products in the midst of a real estate melt down that goes on and on.

People need a better understanding of what this kind of leverage is. And derivatives really represent leverage on top of leverage.

The most important thing now is for governments to require financial institutions to be much clearer about what they actually have on their books and what they are selling. Transparency is the name of the game. You cannot have trust if borrowers and lenders simply do not know the value of pieces of paper that have promises on them. Either government is going to bail out and subsidize and insure, or government is going to regulate and make the system honest.

These investment banks are currently having a downtime, but this does not mean the end of the investment banking industry. It will again generate profits in the future. The industry will grow again as it has in the past.

People still need to have their assets managed, people still need advisors. So a good percentage of Merrill Lynch business will remain. There will be plenty of investment deals in the future to provide corporate lending and financing - it’s not dead.

You can also be assured that all the kings horses and all the kings me are coming together to make sure this thing stays together.

The mess gets cleared up and the markets carry on and progress further up. It’s just plain old Economic Darwinism - the strong will survive and the weak will fail. The strong in this case being Bank of America and JP Morgan, the weak being Bear Stearns, Lehman Bros and Merrill..

So realizing this, why do economic and market fears seemingly appear shocking to just about everyone including policy officials, politicians, the media and investors, it’s as if it’s a totally new beast.

No doubt there are a lot of economic problems. The housing and auto industries have been collapsing for the last couple of years, banks continue to write off bad sub-prime loans and wrote down good assets without adequate bids, there have been many months of mild job losses, and real consumer spending has slowed down. And finally there is “fear itself” as seen by the Bear Stearns and Lehman bankruptcies, and the takeover of Fannie, Freddie and Merrill.

What has really collapsed in the last year is not the general economy, or the market, but the aggregate confidence of investors. Fear has been the dominating character of this crisis!

I do recognize the many problems and also worry over their ultimate resolution. I share your concerns around the recent volatility in the markets. However, I think these “challenges” are probably more than adequately accounted for by cautious business behaviors (low inventories, bare bone head counts, and cash-flow rich balance sheets), by amazingly guarded investors (large amounts in Money markets) and by the aggressively stimulative responses employed by the policy officials (injecting liquidity, and keeping rates low).

While there maybe more bad news to come, and certainly there are many things to worry over, I think the “obsession with recession/depression/correction/whatever-ion” is a bit overdone. I believe that the general sentiment is based largely on nightmarish scenarios, which are likely to prove far worse than the ultimate reality. Investors waiting for the “all clear” sign will be far too late. Asset prices (the stock market) in the short term are not established by the underlying reality in the economy, but rather by “perception of reality” or by sentiment. But, in the long term it is the underlying reality that has the largest impact.

The fundamental backdrop surrounding the stock market, the price-earnings multiples are attractive. Despite the crisis, profitability for most companies (non-financials, non-autos, and non-housing) has remained remarkably strong and should improve even more as economic activity recovers. Non-financial corporate balance sheets are healthy, including low debt-to-equity ratios and strong cash flows. There’s also an adequate amount of liquidity being supplied.

I see considerable upside potential in the stock market, because the economic reality will soon show significant signs of improvement and also because current investor sentiment has collapsed much more than actual economic reality. For more than a year, policy officials have been obsessively focused on improving economic and investment outlook. In our view, it is a good bet they will eventually succeed and any perceived improvement in the economy will likely produce outsized returns as overdone fears finally dissipate. We’re entering in my judgment a decade of transparency. Everything will be viewed in the light of what can be seen and how can it be seen.

How bad is it? In US stock market history, has it been this bad before? When, and what were the circumstances? Has it been worse?

It is important to remind ourselves that no one knows what will happen to the stock market from this day forward. The experts cannot agree on what will happen next in important sectors that seem to be influencing the stock market strongly these days (US housing, oil, credit), and no one knows the extent to which the stock market already has assessed the likely developments in these sectors, and factored those assessments into stock prices.

From history’s perspective, in terms of market decline, the bursting of the technology bubble in 2000-2002 was worse.

The current market is the kind of market downturn that we as investors must expect and factor into our investment decision-making. It is unusual, but it’s far from “the worst in living memory.”

After the 1987 stock market crash, when the Canadian market fell about 22.5 percent, it took 21 months to get back to even. After a decline of about 11 per cent that followed the 9/11 terrorist attacks, it took the Canadian market 47 days to recoup its losses.

In August 1998, during the Russian financial crisis, the S&P/TSX composite fell more than 20 per cent. It then gained 109 per cent over the next two years.

So, will this decline continue to get worse, or will stock prices begin to improve soon? Unfortunately, there is no way to know. Stock prices could continue to go down, or they could begin to rise again.

We can take some comfort from our diversified approach. For example, while the financial company stocks have suffered most severely in this decline, our exposure to them has been limited, especially because of our exposure to utilities and our equity portfolios, while they have declined, have declined far less. We can take comfort in the knowledge that we have managers that have gone through markets like this many times before and succeeded after them. We can take comfort that almost every time after events such as these the markets have been higher five years down the road. Twenty years ago we saw something similar with Drexel , today it is Merrill’s time. We rallied back strongly from Drexel and we’ll recover from Merrill.

The Canadian banks are well capitalized and well run. What we are seeing is a disturbance to the financial system as a result of some investment banks getting into difficulties in the US. What we have is a bubble bursting, and whenever a bubble bursts it is extremely uncomfortable. We saw that when the dot coms collapsed.

There are lots of observers making assumptions that they shouldn’t. Do we really think the banks aren’t taking steps to strengthen their capital position? A rumor is still a rumor. Period.

At this point it’s easier to be pessimistic, the non-financials are still strong - you still need to shave and brush your teeth and for these you need to purchase consumable products.

One thing I have learnt is that capitalism is extremely resilient, and it is about destruction as well as creation. If you look at previous financial crises they worked themselves out within a year or two: the Russian debt default; the collapse of Long Term Capital Management; the end of the dot com bubble. All were dramatic, but all of these had little profound long-term effect.

Today’s environment is not as scary as it seems. This is a time when a certain steeliness and common sense needs to be reasserted. A year from now I believe we will be looking at a much improved position

When will the markets start turning around? Maybe next year, maybe next week.

Jack and Max are walking from religious service. Jack wonders whether it would be all right to smoke while praying.

Max replies, “Why don’t you ask the Priest?”

So Jack goes up to the Priest and asks, “Father, may I smoke while I pray?”

The Priest replies, “No, my son, you may not! That’s utter disrespect to our religion.”

Jack goes back to his friend and tells him what the good Priest told him.

Max says, “I’m not surprised. You asked the wrong question. Let me try.”

And so Max goes up to the Priest and asks, “Father, may I pray while I smoke?”

To which the Priest eagerly replies, “By all means, my son. By all means. You can always pray whenever you want to.”

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Moral of the story is… the reply you get depends on the question you ask.