Comments 2012

May 2012

"The stock exchange is a Paternoster. It is not dangerous to go through the basement. You simply need to keep your nerve" (John Kenneth Galbraith, *15.10.1908 - †29.04.2006, economist).

Since the beginning of the new millennium stocks have had a very disappointing performance. In the past, long term growth in value has been very impressive, but the increase hasn’t been even or constant. Investors have periodically lost large parts of their funds. In 1973-1974 during the oil crisis, in 2000-2002 after the burst of the New Economy bubble and in 2008-2009 in the financial crisis they have lost 50%. These are traumatic events. During these down periods it is paramount to remember the positive sides of investing in stocks.

From 1950 to 2011 CHF 1 million invested in world stock markets has grown to CHF 170 million. A balanced account with 50% in bonds and 50% in stocks has grown to CHF 63 million while a pure bond account has grown to CHF 18 million. The higher the equity component the higher are volatility but also return.

Since equity investments have the best long-term returns, question arises, when is it opportune and relatively safe to invest? We all know that perfect timing is impossible, but whenever there is maximum uncertainty, fear and hopelessness during a severe crisis, then stocks are in the “value-zone” and can be bought for enduring, positive performance. This has been the case in 1973-1974, 2000-2002 and in 2008-2009. In addition in Europe, in the fall of 2011, valuations have been in the value-zone.

Since the stock market is an elevator, what time horizon is needed for a recovery, in case our entry point has been inopportune? If we enter the market in a rosy time of high valuation and overconfidence, it may take up to ten years to beat a low risk bond portfolio.

April 2012

To be pessimistic on Europe is chic. No investment comment or article, which doesn’t mention the plight of the financial crisis and the overindebtedness of European countries, problems which weigh even more on the area because of a lack of united leadership and the north - south diversion. Since the Euro Zone could quite possibly dissolve, the conclusion is to avoid for the time being investments there.

One could also deduct more positive consequential effects. Europe realizes that it is unable to finance its overblown social systems and has to cut them back. Oversized debt levels have to come down, because otherwise creditworthiness is lost. Slowly the insight, that mere cosmetic changes will not help, that there has to be a fundamental change, sinks in. Europe still is in an enviable top position in culture and technology. We may lack a compelling united leadership, but the manifold nationalities, the rich cultural biodiversity, the decentralized democracies render us more creative and hopefully more determined in a crisis then the more aligned other big powers. So far the will to pursue a united Europe and to make the necessary sacrifices has prevailed against centrifugal forces.

Investors have to consider in addition the low valuations presently attributed to European markets. Weighing all these factors we find the risk to return ratio favorable, despite the uncertainty. We also keep in mind that the last quarter was one of the best for equity markets. A correction would be no surprise, but would also not preclude a more constructive attitude toward European securities.

March 2012

In the second half of 2011 the European banking sector was under immense strain and in danger of collapsing. Badly indebted peripheral states with huge and growing deficits, immense losses in collapsing real estate markets and in other inflated assets eroded confidence. Stock prices plunged to record lows, which made capital raising operations almost impossible. Political haggling and indecisiveness added to the explosiveness of the situation. Conviction was high that our financial markets could crash.

In late 2011, the ECB offered to European banks long term financing at 1% interest. This move has lifted the danger of an inevitable liquidity squeeze. Banks have now much more room to maneuver, they are able to lend and have more time to deleverage. The danger of contagion in sovereign debt markets among weaker states has diminished. For the time being a collapse has been avoided. Heavily indebted countries still face a huge task to lower deficits and reduce mountains of debt to sustainable levels. This is even more difficult, when they have to do it in a recessionary environment. However, there is probably no better way to correct excesses of the past than austerity, as harsh as it is for those affected. Discontent and anger are high, but it’s possible that we have reached the trough.

As the European and global picture stabilizes, the recovery in the financial sector could prove sustainable. The financial sector can never be counted out. It is a big sector at the heart of the economy and is thus key to an economic recovery. There is no assurance that the present recovery continues, but we think the worst could be behind us.

February 2012

Mario Draghi became President of the European Central Bank 100 days ago, at the beginning of November 2011. He started at a dangerous point of the European financial crisis. Interest rates for long-term debt of Spain and Italy had jumped above 7%, a threshold indicating that markets had lost confidence in their ability to stay solvent. France and its banking system also encountered growing doubts. Most European banks no longer could raise public loans without collateral, putting in question their ability to roll over billions of maturing debt. To make matters worse, rating agencies threatened drastic down-ratings.

Despite immense pressure the ECB and Draghi continued to demand reductions of deficits as condition for help and financial support. To alleviate the danger of a liquidity crisis he offered the banks inexpensive loans for three years against collateral. By insisting on a reduction of deficits in times of a contraction of the economy, the danger of a recession has increased, but the ECB insists that there is no other way to correct this culture of growing deficits and to regain a healthier base for growth. Surprisingly, mood and psychology of markets and investors has changed somewhat. After pessimism, panic and total abstention, some confidence is returning and investment activity is returning on a low level. This slight change in psychology is not resolving the problems of peripheral European countries, but it could give them more time to work on solutions and reduces the danger of a collapse. In this regard Mario Draghi has done a good job in his first hundred days.

We also have good news on our own. The Jolimont Value Fund, a Swiss Fund denominated in Euro, has had in the category "Absolute Return Funds" the best performance of all funds over the last 3 years. There was a significant loss in 2008, but since that time we have recovered nicely and this is positive.

January 2012

2011 was a very tough year, in particular for Swiss- and Euro- and less so for Dollar-investors. After a promising start the financial crisis in Europe reared its ugly head again in the second half of the year by spreading out to Spain and Italy. An ill-conceived element of the Greek solution, the inclusion of private lenders in the losses, at first of 20% and then 50%, threw them in a state of uncertainty not only regarding Greek debt but including all Southern European countries. To stop the run the EU had to create the EFSF (European Financial Stability Facility) with a capital of EUR 700 billion. When this proved insufficient the countries of the Euro-zone decided to establish a stability union with strict limits on budget deficits and levels of debt. They also declared the cut on Greek debt as a singular, exceptional move which would not be repeated in the future. Further, the European Central Bank provided European Banks with inexpensive 3 year loans, supplying them with sufficient liquidity for the time being. In the wake of the crisis all governments of Southern European countries lost their mandates and have been replaced by new teams which hopefully are fitter for their immense task.

European governments hope to tame the crisis with these moves. While their handling so far has been slow and piecemeal, they nevertheless have now put in place stringent fiscal conditions and seem determined to enforce them. In addition EFSF and IMF offer considerable financial firepower to contain a crisis, not least because also the European Central Bank could join the effort, if the member countries adhere to strict fiscal discipline. This is so far a positive development. Their resolve will definitely be tested in the new year and skepticism is widespread. A break-up of the currency union on the other hand seems very unlikely. The consequences for the Southern European countries would be catastrophic and would probably lead to a worldwide crisis of unknowable extent.

The turmoil in Europe affected European stocks dramatically. In August and September prices crashed, almost similar to the crashes of 2001-2002 and 2008-2009. Credit Suisse publishes an anxiety-indicator, the CS Risk Appetite Index. It plunged, like in the two preceding crashes, into panic-territory and has since remained there. On the other hand, a safe-haven-currency like the Swiss Franc temporarily rose over 20% against Euro and Dollar.

US blue chip stocks were able to hold their level more or less, but European stock markets crashed. European blue chips, represented by the Euro Stoxx 50 index, can presently be acquired at book value. The only other time they have been so cheap was in early 2009. Imagine, the 50 most representative companies of the Euro-zone can be bought at book, without any premium. They historically earn 10 to 15 percent on their equity and book value and earnings have kept growing over the years. But today most investors prefer to place their money in bonds earning between 1 to 2% with no chance of growth. The reason for this strange behavior is fear. Fear concerning the high debt of most economies and private households, fear the economies could plunge into recession, high unemployment and a frail banking system. They also doubt that the Euro will survive much longer. All these negative scenarios are possible and they are foremost in the public’s mind. Thus it overlooks the fact that new governments have a mandate to restore public finances to health, that banks have raised billions in new equity, they continue to do so and also shrink their balance sheets. There exists now a safety ring in the form of the EFSF and the IMF stands also ready to support nations under stress. Finally the European Central Bank has indicated its readiness to support struggling members, if they adhere to sound fiscal policies, without giving them a blank cheque.

In good and bad times investors should never forget that economies are always subject to cycles, they don’t progress in a steady way. Human beings have the tendency to project the present situation into the future. If times are bad they expect them to remain bad and if they are rosy they see them continuing on this path. But good times don’t last forever and rough times end. Banks get more cautious after having suffered heavy losses, risk aversion rises and only the best addresses get loans. Private households cut back on spending and start saving. Weak competitors run into problems, some become insolvent. Returns on loans and stocks start to rise. Contrary to the trend some courageous investors enter the market and are successful. Capital flows again into the economy, consumers are returning and growth resumes.

As a rule one can say that macroeconomic predictions are generally imprecise, because there are just too many unknowable factors influencing the outcome. From time to time a forecaster is right, his esteem rises, but often his next prediction is off the mark. Correct economic previews seem to be coincidental rather than reliable. However it is possible to get a picture where  in the economic cycle one stands. Is there euphoria or pessimism, are positive developments being commented or is there obsession with negatives, are assets overpriced or underpriced, does greed or fear reign? Today we are clearly in fearful mood with the anxiety-index in panic territory. It’s possible that we are close to a trough. There is no guarantee that it won’t get worse, but chances of a turn are rising. Those who buy now buy cheaply and have a good chance to make a profit.

The cost of fear also has shown up in currency swings. In August, at the crest of the crisis, Swiss Francs rose over 20% against Euro and Dollar, although the franc was already heavily overvalued in regard to Purchasing Power Parity. Almost all currency experts predicted nevertheless a further strengthening, because the flight into a safe-haven-currency would continue. Now, four months later, this advice has proven completely wrong and Dollar and Euro have recovered to the level at the beginning of the year. This illustrates how fast generally held opinions can change.

Nobody can reliably predict the future. We face huge problems, which won’t easily be resolved and it will not happen over night. Earlier mistakes and sins have brought us turmoil, which at first has been handled poorly. On the other hand we here in Europe seem to be close to a low point with nerves blank and pessimism rampant. Most problems are known and efforts to resolve them are under way. A quite negative mood and high anxiety are depressing valuations. No bells will ring when a recovery will get underway. The courageous will be well rewarded. Those who wait for a more positive consensus could miss the train.