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July 18, 2008 Financial markets around the world were hit pretty hard last week. And while this week has been better, it is hard to remain upbeat with all the stories of woe coming out of Wall Street. We have had round after round of new write-offs from the big banks and Fannie Mae and Freddie Mac. These two big Government Sponsored Entities (GSEs) that hold or insure about half of the nation's mortgages came under fire, and their stock prices dropped sharply. Finally, last Friday we had IndyMac Bank fail; the second largest bank failure in the U.S. The problems at the big financial institutions stem from two big mistakes. First, mortgage lending standards were way too lax. For example, IndyMac Bank was the biggest "alt A" (meaning low or no borrower documentation, low income or downpayments) mortgage originator. Why on earth lenders thought no documentation loans were a good idea, we will never understand. Lending standards are once again all nice and tight, four years too late. Now we face some short-term dislocations from legitimate worries about bank failures and a stiff head wind from the general tightening of credit conditions. In the short-term it hurts, but in the longer-term it is a good thing. Second, a group of big, prominent financial institutions lost sight of risk control and built up huge portfolios of mortgage and mortgage related securities. With high leverage comes high risk, so when a relatively small slice of the mortgages started to default (mainly sub prime and alt A's), the high leverage began wiping out their capital pretty quickly. With all the carnage on Wall Street, it is important to bear in mind that most of the U.S. credit market remains healthy. The Lehman Aggregate Bond Index, which is representative of the entire U.S. investment grade debt market - more than 90% of total debt, is doing just fine, with a positive total return. And the non-investment grade debt total, while suffering, is in general not doing all that badly, with corporate high yield down about 4% over the last year. These mortgage issues remain highly concentrated, but also highly visible. As we have said before, our big concern is the price of oil. Oil prices are just way too high, and we are seeing substantial energy demand destruction and the beginnings of supply increases. Statements that market prices always reflect normal supply and demand are, to me, silly. Oil prices dropped $16 over the last three days; that's not normal. Hopefully, we are breaking the speculation in oil, and prices will continue to fall. We are worried about all this, as I am sure you are. We do think we are pretty far along in the corrections in housing and the banking system, and we are very impressed at our economy's ability to weather these two major shocks. While it looks like we avoided recession in the first half of the year, we think high oil prices, if sustained, may push us into a shallow recession in the second half. If so, what does this mean for stock prices? The old adage is that the stock market is six months ahead of the economy, and right now it looks as though financial markets may already have a recession priced in. Financial stocks have generally been crushed, and most other sectors have, in our opinion, been beaten down to historically low price/earnings ratios. At times like this it is very tempting to throw in the towel and just go to cash. We wish we could tell you with assurance that we are "at the bottom", but neither we nor anyone else can predict the stock market's course over the year ahead with any assurance. But we can tell you that more often than not, these periods of bear market territory declines are followed by swift, and unpredictable, recoveries. The protracted decline from 2000 through 2003 is very much the exception, not the rule. So, while it looks like "time to do something", we think that most often backing away from the equity market at times like this proves to be a mistake.
The enclosed contains Westside Investment Management’s own opinions, and none of the information contained therein constitutes a recommendation by Westside Investment Management that any particular security, portfolio of securities, transaction, or investment strategy is suitable for any specific person nor should they be acted upon in any way. You further understand that Westside Investment Management will not advise you personally concerning the nature, potential, value or suitability of any particular security, portfolio of securities, transaction, investment strategy or other matter. To the extent any of the information contained in this posting may be deemed to be investment advice, such information is impersonal and not tailored to the investment needs of any specific person. Westside Investment Management's past results are not necessarily indicative of future performance. The material enclosed is for general information and educational purposes only and are not intended to provide any specific advice or recommendations for any individual.
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