Thank you for having me today; it is a pleasure and an honor to be here. My goal is to shed light on some key economic trends and their potential effects on the financial markets and then briefly discuss how we are positioned in the products I formerly managed.
Initially, the suggested title for my talk was, “The ‘First” Pessimist’s View of Today’s Markets,” while last year’s Fortune magazine interview with me was titled, “The Man Who Sees Disasters.” These sound pretty negative. Rather than being a pessimist or disaster monger, I prefer to view myself as a realist. My conclusions are based on extensive critical thinking and evaluation.
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Accordingly, I decided to title my talk, “CAUTION: DANGER AHEAD,” because of the risks I perceive.
Before discussing these risks, I would like to share three lessons I learned early in my 41 year investment career that have served me well. I feel they have helped prepare me for these uncertain times.
1. Being overly optimistic can be harmful to one’s pocket book
2. Understanding the concept, “the Margin of Safety,” and the value of historical awareness in protecting capital.
3. Discovering and internalizing the idea of what I termed, “the investor delay recognition period.”
In 1971, I entered the investment field bright-eyed, optimistic and self-confident, believing that high investment returns were to be expected. It didn’t take long for me to realize how mistaken I was. My inexperience prevented me from understanding the nature and significance of the demise of the Bretton Woods accord that year, which ushered in the era of floating exchange rates, and the importance of the 1973 oil embargo. These were structural-change events that were initially misdiagnosed or misunderstood by investors in general and led to international trade instability, higher inflation and weaker corporate profits. When the equity market subsequently collapsed in 1974, I learned what it truly felt like to lose money and be fearful. Fortunately, the events of that year drove me to investigate and discover why this unfortunate outcome had occurred. I found Graham & Dodd’s 1934 edition of Security Analysis in which the authors extolled the virtues of investing with a “margin of safety.” Additionally, I met Charlie Munger in my USC graduate school investment class and had the opportunity to ask him this important question, “If I could do one thing to make myself a better investment professional, what would it be? He answered, “Read history! Read history! Read history!” This was among the best pieces of advice I ever received.
My investment education was further enhanced by the events that led to a dramatic rise in interest rates between 1979 and 1981. By 1979, the ten-year Treasury bond’s real yield had become negative and that was after four years of negligible compensation for the level and rate of increase in inflation. Newly appointed Fed Chairman Paul Volker, for whom I have great respect, initiated an aggressive attack on inflation by rapidly raising the Fed Funds rate. The stock and bond markets were slow to respond to this important policy change. This led me to the realization that most investors, faced with structural changes, experienced a delay in their recognition and understanding of the implications of these changes—“the investor delay recognition period.” This is why I constantly admonish investors to beware of following the crowd. You have to do your own thinking and reach independent conclusions. Recognizing structural changes may mean that both strategic and tactical adjustments in the management of money are required. Implementing these changes can be a risky business strategy. If one anticipates events or trends too far ahead of the general consensus, the prospect of under performing the market and losing clients is all too likely. I can attest to this from my own personal experience, since by the time I was proven correct, I had suffered significant client defections. As John Maynard Keynes wrote, “Worldly wisdom teaches it is better for reputation to fail conventionally than to succeed unconventionally.” I cannot subscribe to such an expedient philosophy because of personal ethics and dedication.
These lessons helped equip me for the events and challenges to come. 1998 was a seminal year for me since it is when I came to realize that macro event thinking was taking on far more importance in my strategic investment thinking. In March, I argued that holding a high cash level would not be detrimental to long-term investment performance.1 Instead, it would provide downside asset protection and flexibility. This view was completely out of sync with the norms of the investment management industry and was of great concern to my clients and shareholders. It was a radical change in my investment strategy, after 14 years of averaging between 1% and 3% liquidity, a period in which I would not have been labeled as being a perennial pessimist or worse. From March 31, 1998 to year-end 2009, when I stepped down from active money management, a 3-month Treasury bill achieved a 3.1% annual total return while the S&P 500 and the Russell 2000 returned 1.9% and 2.6%, respectively. The Russell barely beat the CPI’s 2.5% average inflation rate. The FPA Capital Fund, my equity fund, attained an 8.2% return, with considerably less risk than the market indexes, since liquidity averaged more than 25%, with an ultimate peak of 45% in 2007.
I battened down the hatches and prepared the portfolios for each of the greatest investment bubbles of our time: the 2000 stock market bust and the credit collapse beginning 2007. I wrote and spoke frequently about the coming dangers of each, but with little impact. Chairman Greenspan’s unwise monetary policy, between 2001 and 2003, was quite disturbing to me. I viewed it as foolish because it might trigger another bubble, possibly in real estate, which could prove to be larger in size and more harmful than the bursting of the recent stock market bubble. Dr. Kurt Richebacher’s economic letters, to which I had been a subscriber for years, first warned of this possible outcome since he was extremely critical and fearful of the Fed’s easy monetary policy. His thinking was grounded in the Austrian school of economics. Paul Volcker said in 1982, “Sometimes I think it’s the job of each Fed chairman to try to prove Richebacher wrong.”2
Dangerous credit trends began to appear in 2005. I believed a major credit bubble was emerging and that precautionary actions were warranted. Because my skepticism was so deep, it led to my having a nightmare in early 2006 that was captured in the prologue to Roger Lowenstein’s book, The End of Wall Street. I imagined Fannie Mae and Freddie Mac had filed for bankruptcy. The dream was so vivid and compelling that it helped to solidify my analytical thinking about the credit bubble. The following morning, after consulting with legal counsel on the implications of a bankruptcy filing, we liquidated all corporate debt holdings in both companies, representing approximately 40% of our fixed income assets. It was dawning on me that a potential tectonic shift was in the process of taking place in the U.S. capital markets. Thus began one of the most difficult, but also most rewarding, strategic shifts I ever made in my career.
By the spring of 2008, the unfolding financial crisis impacted me so profoundly, I wrote in my commentary, “Crossing the Rubicon,” that, “…a new financial system is in the process of being created. This is the beginning of a new era.”3 It was a warning of the dangers to come. That fall, the potential of accelerated Treasury debt growth captured my attention. I estimated that it would rise to between $14.6 and $16.6 trillion, by year-end 2011, from $10 trillion. Once again, my conclusion was viewed by many as being too dour, rather than realistic, which it was proven to be since total U.S. debt stood at $15.2 trillion at year-end 2011.
I hope that this brief historical review of my career should help allay fears that what follows does not come from the likes of a perennial pessimist and doomsayer. Neither does “CAUTION: DANGER AHEAD” spring from recent capital market volatility. Oh, No! When I left to take my sabbatical for a year in 2010, I conveyed to my associates and clients that the current crisis was only Phase 1, and the coming year would prove to be simply an interlude. If the nation’s unsound fiscal policies persisted, within 3 to 7 years, it would face another financial crisis of equal or greater magnitude, and it would emanate from the federal level. I wish I had said sovereign level, covering all my bases, but I did not arrive at this conclusion until once away on sabbatical when my attention and thinking shifted to the international area–European sovereign debt in particular.
Phase 2 is now beginning and I think we are on the cusp of a decade of extreme economic and financial market turbulence. Uncertainty as to the effects of high system wide financial leverage and the outcome of the battle to determine what the proper roll and magnitude of government should be within an economy are key elements in this future turmoil.
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