LJL Funding Blog

Previously we commented on the fact that a long term buy and hold strategy in the stock market may not have been the wisest of decisions because of the significantly long periods of sideways price movement clearly illustrated in the chart below. The boom of the roaring 20’s that followed WWI; the three decades boom time following WWII and the 80’s and 90’s technology boom were all interrupted by periods of sideways price movements each lasting between 13 and 16 years. An argument can be made that we are in one of those sideway periods that started with the implosion of the dot com bubble in 2001, during which time we enjoyed a brief respite thanks to the Fed created cheap and Congress mandated (forcing banks to make mortgages available to people who could not afford it) easily available credit essentially based upon real estate. We are now experiencing a sluggish sideways to moderately down recovery in the housing market; a tired looking stock market; more optimistic consumers without jobs and an economic system requiring an overhaul that in itself could put a stranglehold on future growth reminiscent of the Sarbannes Oxlee chokehold over public companies. If we are indeed in one of those long term sideways cycles we may well see a recovery in 2014 to 2017 and the challenge would be to identify the theme for the next major bull market (previous themes were post WWI and WWII spending to rebuild the world and the technology revolution). In the sideways scenario lasting for another couple of years investors would be wise to focus on secured investments that would yield consistently high yields with low volatility – THE LJL SECURED HIGH YIELD INCOME FUND.

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With information being disseminated throughout the world instantaneously it would appear as if economic problems of virtually any magnitude can be resolved in an extremely short period of time. In October 2008, the world as we know it was coming to an end, by March 2009 popular belief was that the end was still near, but not quite as near, now a few months later , not only is the end no longer in sight, but opportunities abound for the new recovery. Governments are talking about the end of stimulus packages; liquidity could become available to the general economy in the near term as the banking crisis judged by the TED Spread at below 50 basis points seemed to have been resolved; the stock market is in positive territory for 2009; housing prices are continuing to decline but at a much reduced pace; foreclosures still high are lower than a month ago; banks are no longer dumping REO’s en masse and consumer confidence is up. Just as this economic crisis was the worst since the 1930’s it also provides us with the best opportunities since the 1930’s with all the rebuilding that is required. Investors would be wise to remain extremely cautious as the seeds for this recovery – massive governmental capital injection into the economy – have not yet had time to generate fundamentally sound economic foundations for future growth. We need new business development, new job creation, increases in productivity and earnings including wages, all of which may well be on the way, but until they arrive be prepared for major swings in prices and sentiment that will test the strongest of investors.

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The bulls on Wall Street took a breather, well deserved after running for six weeks, but the rest of the economy continued, albeit at a snail’s pace, to absorb bad but better than expected news. The Chrysler bankruptcy and a likely filing by GM with the resulting closures of thousands of dealerships are anticipated to cause pain, but not the end of the world. On the real estate front commercial real estate seems to be falling off a cliff with residential now only rolling down a steep hill. Foreclosures are up, as can be expected after an imposed moratorium, but are being handled in a fairly orderly fashion with the Obama administration even giving incentives for a “cash-for-keys” program designed to facilitate an orderly, quick and less expensive way to reach what in many cases are the inevitable end result. The bursting of the housing price bubble and the implosion of the subprime mortgage backed securities market was the catalyst for the frozen credit markets that nearly brought the world economy to its knees. Without the credit markets regaining full functionality there should not be any sustained recovery. During the week under review the thawing of the credit markets accelerated with the placement of $2 Billion (oversubscribed) bonds by Citigroup without any government guarantees. One of the significant measures of the health of the credit market the TED Spread ( spread between 3-month Treasuries and 3-month LIBOR) narrowed to 62 basis points, well down from nearly 500 basis point at the height of the crisis and fast approaching the normal range of between 35 and 50 basis points.

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The woes of investors were primarily caused by the frozen credit markets when banks and financial institutions on a global scale lost confidence in each other and resulting in a total freeze of the system. As we have often discussed – the TED spread (difference between the risk free 3-month Treasury Bill and the 3-month LIBOR) clearly reflects the state of the credit markets and the willingness of banks to lend at least to each other. In normal times the spread is lower than 50 basis points; during the height of the crisis it approached 500 basis points and in recent weeks have traded around 100 basis points. During the week under review the spread was in the 70 basis point area. Clearly the results of the banks stress tests have moved the debate from a bottomless pit to a floor with realistic required capital targets. Investors should be breathing easier as we face a more normal market were volatility will still be at the order of the day, but profit taking will not indicate the end of the world.

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High returns are always commensurate with higher risks. It appears as if we are emerging from the apocalyptic destruction of investment portfolios of 2008 and early 2009. The economy and the markets for the elements contributing to the economy are fragile, fraught with uncertainty, in the case of the stock market showed a 20%+ bounce back and in other areas at the very worst the rate of decline has and is slowing, all indicating a return to normality in 2010. Balancing returns and risk has now taken on a greater degree of importance, and in the case of aging baby boomers, a greater sense of urgency. The challenge is identifying an investment with an expected yield high enough to produce the required end result at a risk level that would not induce sleepless nights and panic. Decisions made in a state of panic invariably produce the wrong result, which in the case of investments mean selling at the bottom, when all hope is lost, and buying at the top, when the fear of missing more appreciation leads to action. Volatility (swings in prices) is often the cause of panic and the resulting wrong decisions. Fundamentally the investment may be sound, but the changes in price is just too hard to take. A prime example is Berkshire Hathaway, run by the Oracle of Omaha, Warren Buffett, long regarded as the investment all star of all stars (See price chart in the Stock Market Section). Statistically the standard deviation measures the consistency of returns. Given two investment opportunities the wise choice could well be the opportunity with the lowest standard deviation or the most consistent returns. A number of more definitive risk adjusted ratios are used to further quantify volatility and therefore the level of risk associated with each investment opportunity. These risk adjusted return statistics are discussed in greater detail in the Investor Section below.

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The stock market continues with optimistic overtures and we may well still see some upside in stock prices, especially since there are also other economic indicators in housing and manufacturing that are starting to suggest improvement or are they? The stock market traditionally improves well before any true economic revival, as it anticipates future improvements in the economy, but it would be wise to remember that in the 1930’s the stock market had four 20%+ rallies that failed and were followed by new lows. Carefully analyzing the improving economic fundamentals also suggests that rather than improving the rate of decline has slowed and in some cases even flattened out but are not necessarily improving. Equally corporate earnings may be beating expectations, but expectations are now so low that beating the expectations merely indicate that things are not worsening. At the core of the financial crisis is the frozen credit markets and as we have discussed previously, one useful indicator is the TED spread, the spread between the 3-month Treasury Bill (risk free investment) and the 3-month LIBOR ( the rate at which banks lend to each other). Clearly there is more risk in interbank lending than lending to the US Government, but traditionally that spread was less than 50 basis points. At the height of the crisis the TED spread was around 480 basis points. In recent weeks it has settled around 100 basis points. In terms of our previously used metaphor, below 50 basis points the patient is healthy; between 50 and 100 basis points the patient is ill, but at home; between 100 and 200 basis points the patient is hospitalized and above 200 basis points the patient is in intensive care. Today the patient is out of hospital but is struggling to heal. (See the chart below).

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Spring continues with signs of renewed growth in the economy. Earnings reports are down but not as bad as expected; JP Morgan successfully raised some capital with Goldman Sachs in hot pursuit; some banks are even talking about paying back their government aid and the NYSE enjoyed a successful IPO. The world as we know it, may in actual fact not come to an end right now. With the panic subsiding the sobering reality of a generation’s lost savings – the vision of a large leisure industry catering for early retiring baby boomers, now a distant memory – needs to be addressed. This will require a realistic and quite possibly a painful assessment of projected investment returns over the next 5, 10, 15 and 20 years as the baby boomers move into their twilight years. Absolute returns and as importantly volatility (pain that can be endured during market price fluctuations) will no doubt become extremely important and ratios such as the Sharpe and Sortino ratios, both measuring returns and volatility could become household words.

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Spring is in the air and it appears that the frozen financial markets are thawing. Leading economic indicators from stocks to manufacturing to spending and even in the housing market with number of houses sold and the rate of change in the lower tier price range all indicate that a bottom could be reached in the last quarter of 2009 or in the first quarter of 2010. General consensus (normally wrong), would suggest that the recovery would not be robust but at least the sentiment changed from focusing on a world ending depression. Investors who have weathered the storm on the sidelines or participated in what likely will amount to a Treasury bubble should start looking for ways to rebuild reduced financial holdings. The stock market which is the most likely investment arena remains volatile and it is more than likely that a test of the lows which invariably happens before the bulls totally return would challenge the mettle of the most battle hardened investor

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Whether it is wishful thinking or not, brief signs that things may start to improve continue to appear. Better than expected (we have to acknowledge that expectations have been decimated) economic news from manufacturing to consumers to housing were at the order of the day this past week. The biggest rally in stocks since 1982 took a short breather on Friday and may continue this week. If history is any guide, investors should be wary as a successful test of the lows first in October, which did not hold in March, has yet occurred. Historically very few trends, up or down, are reversed without a good solid failed test. The bond market and the TED spread (3-month LIBOR vs 3-month Treasury) are still flashing danger signs, both of which need to recover before the credit markets will return to normal.

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There is nothing like a good public lynching to take one’s mind off any real problems. The executives at AIG with their bonuses and Bernie Madoff’s request to be released from prison provided enough ammunition to rally the public into a mob. One of the victims may be senator Dodd, who coincidentally along with congressman Frank were responsible for launching the catastrophe in the mortgage market by spearheading legislation to force banks and financial institutions to provide mortgages to people who could not afford such loans. On a more positive note, the housing market continues to show glimmers, albeit small, of hope that we are indeed approaching a bottom at least in some sectors of the market. The stock market is up 12% in two weeks and the credit market is also showing some signs of thaw. Inflation appears to be the next headline with commodities led by gold raising the alarm. It is true that central banks are printing money on a pace unequalled in history, but before we all sell everything (or what is left of everything) and buy gold bullion it is important to recognize that a large portion of the newly printed cash will merely replenish losses required for a stable banking and financial system and therefore not become readily available to chase goods and services at ever increasing prices. In addition China with its own fiscal stimulus package will increase its existing manufacturing capacity, a significant part of which is already idle, thus providing the world with a surplus of goods once spending returns. Both the replenishment of lost capital and excess production capacity should limit any immediate inflationary concerns.

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