Download An Open Letter to Clients – January 2008

An Open Letter to Clients – January 2008
As I write this letter on January 25th, after four years of relative calm, markets throughout the
world have experienced the most wild and volatile start to the year in decades!
The Big Issue
According to the media the big issue is whether or not the US is heading for a recession. The US
is the largest economy in the world and the pundits seem to think that if the US slows, every
country will be affected adversely.
Personally, I think the real issue is far more significant and “systemic”. The world is awash in
debt, particularly in the United States. In my last letter I wrote about the burgeoning US debt.
For readers new and not so new, I’ll repeat the figure. They have $55,000,000,000,000 (that’s
Trillions) of unfunded liabilities.
What is a recession?
Technically, its two consecutive quarters (3 months in a quarter) where the nation’s gross
domestic product (that’s the total dollar value of all of the goods and services produced) declines.
So imagine for every $100 of production last quarter, they produce $99 this quarter and $98 the
following quarter-that’s a recession.
If the economy “shrinks”, generally speaking, companies don’t make as much money and
therefore they aren’t worth as much in the investors’ eyes. Hence, the down draft in the markets.
Prime Time News and Sub Prime Loans
So how did we get here? Why are a lot of these big financial institutions around the world taking
such big write downs? Why is this stuff all over the news?
Good questions. Some of the biggest institutions have taken some severe hits: Citigroup, Bear
Stearns, Merrill Lynch, Credit Suisse, BNP Paribas, CIBC, etc, etc. have all been exposed to this
sludge.
I can’t say for sure how it all started or who is to blame. But here is my interpretation of some of
the key events.
Maybe you’ve heard of Alan Greenspan, the former Chairman of the Federal Reserve Board in
the United States (their job, in part, is to help manage the economy). One of the ways they can
influence the economy is by increasing or decreasing short term interest rates. In theory, if rates
fall, business activity is stimulated. Conversely, if rates rise, a slowing of activity should occur.
In my humble opinion, recessions and slow downs are necessary for the overall health of the
economy. It’s sort of a jungle thing. The strong survive while the weak die off, not unlike the
cycle of life. Nothing lasts forever. So it seems to me that businesses which are well-operated
can survive slow downs and ultimately benefit from down turns as their weak competitors don’t.
Does this make sense to you? It does to me. Poorly run businesses, and for that matter, societies,
should not be rewarded for being inept. That’s capitalism. That’s business and that’s life!
Again, it’s just my opinion, but it seems that almost every time there was a hint of a slowdown,
Alan Greenspan lowered interest rates. This enabled weak companies to stick around longer
than they should and it also led to extreme speculation. Don’t believe me? Try this one on for
size. Imagine lending $500,000 to someone who is purchasing a house for $500,000 (in other
words, no money down). On top of that, this person has already been bankrupt, owes chunks on
credit cards and can’t even provide proof that they earn enough to pay their monthly mortgage.
To add more insanity to the equation, this person gets a “preferred” short term enhancement in
the form of a ridiculously low rate, say, 3%, and only pays the interest! Isn’t this nuts? You bet
it is!
Now what would possess any one in their right mind to loan money on such terms? Well,
imagine you could borrow money at a very low rate and lend it out at even a slightly higher rate.
What a deal! It’s like shooting fish in a barrel as you could borrow an inordinate amount of
money and by “re-lending” it to someone who has a lower credit rating than you, your profits
could be huge! Besides that, there’s “insurance” on that loan. If the person taking out the
mortgage can’t pay, you’re covered. No worries. At least, no worries as long as interest rates
stay low, people make their payments and there are lots of other willing lenders who will take
similar risks.
Well a funny thing happened on the way to “easy money”. Interest rates started to go up. When
interest rates go up property values can decline. And then, POP! There goes the housing market!
Remember the loan made to someone who shouldn’t be borrowing money? That interest rate
spiked upon renewal (typically a few years after the original purchase had been made). In some
cases, such types of mortgages had their interest rates double, even triple.
You guessed it. They can’t carry that mortgage now with higher rates? The keys get returned to
the lender and the downward trend in home prices is off and running. The lender takes the
property back and lists it for sale, after all, they’re not in the property management business.
So who holds all of these mortgages that are turning sour? Based on the write downs we’ve been
seeing in the news, its big financial institutions, pension funds, hedge funds and a whole host of
investors throughout the world.
Helicopter Ben To The Rescue
I think it was 2002 when Ben Bernanke, the gentleman who replaced Mr. Greenspan as
Chairman of the Federal Reserve Board, gave his (in)famous “Helicopter Speech”.
He basically said that the US has a wonderful tool, an electronic printing press. They could print
as much money as they found necessary and drop the dollars from helicopters to put out any
fires.
Mr. Bernanke has studied the Great Depression of the 1930’s and has concluded, in part, that the
Federal Reserve Board of the day didn’t act swiftly enough to help the economy.
The problem with printing money out of thin air is that it reduces the value of the other dollar
bills that are already out there in circulation. It’s simple. The more money you print the less it’s
worth. You’ll need more of it to buy that cup of coffee, that loaf of bread or a pound of bacon.
I’m still convinced that we’re in an inflation cycle, a period of “printing money out of thin air”.
By the way, it isn’t just our neighbors to the south who are doing it. We are too as are the
Europeans, the Russians and every nation I can think of. Simplistically, if we print relatively
less money than the Americans, our currency increases in value. Real assets like precious metals
(which can’t be printed out of thin air), food and energy do wonderfully in “inflationary” times.
It’s still the same tune, just a different day; food, energy, precious metals, water and necessities
of life continue to be my preferred areas of concentration. Yes, these areas can be volatile but so
is life.
Are We There Yet?
Every parent who has gone on a road trip with their children must have heard the above question
before. As it relates to the global equity markets, no one really knows the answer. I suspect that
due to the fact that there are still large dollar values of American Adjustable Rate Mortgages yet
to “rollover” and reset, potentially at higher rates, we may not have “bottomed out” yet. I can
tell you that I see some compelling valuations for some great companies. I’d generally be a
buyer as opposed to a seller at this juncture. I doubt that Warren Buffett is bailing out of his
companies and in fact, he’s been doing some “deals”. People seemingly love a big sale except
when it’s in “financial” assets! Doesn’t every smart investor try to “buy low”?
Seasonal Issues
This year’s deadline for tax deductible RRSP contributions is February 29th. To determine your
maximum contribution room, please refer to your 2006 “Notice of Assessment”. It’s that
statement Revenue Canada sends you after you file your tax return and is light blue in colour.
(Yes, I know-technically Revenue Canada is “CCRA” but I still call them by their old name).
The last few years have been a mess when it comes to tardy receipt of T3 slips during tax season.
This year we’re told that the slips have to be out in a timely fashion. Our expectation is that the
last mailing for T3s should be on April 2nd. Before your return is actually filed, so as to
circumvent the nuisance and potential cost of adjustments, either have your tax preparer cross
reference last years’ return or wait till the last week of April before filing.
New Clients
I do my long term business planning at the end of each year and I’ve been fairly accurate in my
forecasting. As always, I am happy to assist relatives of my clients. Besides being of service to
that specific segment of those whom I serve, I forecast that I will be able to assist six to eight
“new” families this year depending upon the complexity of their respective situations.
Housekeeping
One of the best aspects of my career is that I am able to attend so many interesting events.
Though I’ve plotted out the full year already, here are some dates that are confirmed:
RBC Dominion Securities Directors Council
Orlando Florida
Feb 25th through 29th
Masters Golf Tournament
Augusta Georgia
April 11th through 14th
Berkshire Hathaway Shareholders Meeting
Omaha Nebraska
May 1st through 4th
New York Hard Asset Conference
New York City
May 11th through 17th
There are other meetings with mutual fund managers and investment professionals but these are
the highlights over the next few quarters.
Closing Remarks
I appreciate the time you have taken to read this letter. I think it is important for me to share my
views with you. If you’d like to share this letter with someone, simply direct them to the
following website where it will be posted along with others. The link is:
http://dir.rbcinvestments.com/john.davies
Though the markets have been quite volatile I am very confident in our approach. We appear to
be in an inflationary cycle not unlike the 1970s. As such, I’d expect investments that give you a
natural hedge against inflation should out perform those that don’t. History might not replicate
itself but it sure does leave clues.
Should you like a meeting, simply give us a call at your convenience. I will be seeing people on
select Saturdays and evenings. I can be reached at 519- 252-3517 or at [email protected] .
Erin’s contacts are 252-3671 and [email protected] .
On behalf of Erin Hooper and the rest of the crew at Dominion Securities, I wish you a very
happy day and good health.
Sincerely,
John Davies, CFP
Investment Advisor