Investment and Economic Update

During the first half of 2007, the global investment markets showed strength yet something did not feel right. There were some disturbing developments within the real estate and mortgage sectors that indicated that a major bubble might be bursting. On August 16, my worst fears as a portfolio manager were realized. On that particular day, the stock market had to be rescued from a panic-driven meltdown as a major credit squeeze swept the globe.This credit squeeze was in reaction to heightened fears of hundreds of billions of dollars of potential loan and investment losses stemming from mortgages extended to the riskiest class of borrowers, i.e., the subprimes.

It would appear that these fears were justified. Mortgage loans are now defaulting in record numbers. In hindsight, we were lulled to sleep on the subprime situation by our government. What officially was forecast as a Category One financial storm turned up as a Category Three or Four. It might well become a Five. Now, the talking heads in government and media are ranting about the global financial system needing a Herculean fix as the threat of potentially massive loan and investment losses has intensified. Investment rules are being rewritten and central bankers are using every known tactic to shore up the levees. Although the outcome is anything but assured, the faith in the status quo appears to be undeterred. Still, it is prudent to take some money off the table in times like these, and we have done just that.

My eyes have been opened fairly wide during the last few years. Never before in my professional career have I experienced such a large continuing presence of moral hazard in the markets. What exactly is moral hazard? It is the deliberate avoidance of financial pain at any cost. It is when governments do not allow markets to experience meaningful corrections (i.e., bear markets) so that illusions of perpetual economic prosperity can be run up the flag pole. It is when governments manipulate interest rates, currency rates and the prices of oil, gold and major stock indexes to deliver shots of adrenalin to the markets. When moral hazard is present, rational investing is no longer possible in the short run. Only speculative trading is possible, which amounts to betting on what governments will do in the next day, week or month. For conventional investors, time horizons need to be greatly extended in order for fundamental economic truths to exert themselves. The short run is nothing more than casino action dominated by high-stakes professional gamblers as best personified by the hedge fund community.

Unquestionably, moral hazard creates a false sense of financial security that can loiter for very long periods of time. From a purely fundamental standpoint, there is not much that I see fit to invest in today outside of the Safe Harbor category. However, moral hazard dictates that markets can and will make powerful upward moves even when there are no sound fundamental reasons. As a consequence, being on the sidelines with much of one’s investment capital can be costly. This is all the more true when market rescue missions can be launched with little advance warning, except to the inside operatives. Just when the market is supposed to zig, it can be made to zag. This is an effective trap for keeping investors in the market at all times, even when the fundamentals are notoriously poor. Good timing increasingly is a function of having access to privileged information or committing fraudulent or highly unethical acts. I know this to be true because market tops and bottoms do not advertise themselves. They are most subtle and elusive.