David R. Kotok
Chairman and Chief Investment Officer
P. T. F. S. D.
September 19, 2010
For the last two years, American investors have experienced the evolution of Post-Traumatic Financial Stress Disorder (PTFSD). Many others throughout the world had the same type of shock. It was triggered by the failure of Lehman Brothers and AIG. It grew worse through the 5-week waterfall decline in stock prices in October and November of 2008, and healing did not begin until the bleeding stopped in March 2009.
We have argued for two years that the bear market had two phases. The first was a vicious but normal bear market that started with the peak in stock market values in 2007. That declining phase was discounting the decline in housing values, the financial crisis that was evolving at the time, the failure of Fannie and Freddie, and all the other elements we know. Phase 1 was severe, as bear markets go.
The second damaging phase was equal to the first in monetary size. It occurred after Lehman. It was the second phase, which came as an unexpected shock that caused PTFSD. Phase 2 happened fast. Moreover, merciless in its sweep, it featured worldwide correlation. The combination of phases one and two took the aggregate global stock market value from a peak of $63 trillion in October 2007 to a trough of $28 trillion in March 2009. It also resulted in the demise of the American financial system, as we knew it. Lehman was a primary dealer with the Federal Reserve, and the failure of the firm was unimaginable in the market’s eyes. AIG was the world’s largest insurer; it had subsidiaries in 125 countries. In phase two, the US broadcast its regulatory ineptitude and policy failure to the world. We caused the crisis. It was made in the USA.
PTFSD resulted from the second phase and changed the investment game. It scarred a generation. Only recently are we starting to measure the results. They are very instructive.
The Conference Board publishes consumer-confidence surveys by age cohort. They have been doing it for 30 years. In some brilliant research, Howard Simons of the Bianco Research firm compared confidence deterioration and rebound by age cohort. He then compared changes in confidence by cohort with activity on the US stock market and the US Treasury bond market. Howard’s work explains the results we see in the mutual fund-flow statistics.
The under-35 cohort is gradually regaining confidence, albeit from a very low level. The 35-54 and over-55 cohorts are not. For them the second market phase ending in March of 2009 was a game changer. It explains why the monetary flow into bonds continues and why stocks have such little support among investors, even though they are cheap by many standards. Bianco Research is kind enough to let us share their research piece with our readers. Find it under the “Special Reports” section on our website, www.cumber.com. The direct link is: http://www.cumber.com/content/special/com21v70.pdf . The title is “Age, Confidence and Financial Markets: Older Not Bolder.”
Another asset class experiencing disdain by US investors is the $2.9-trillion Muni sector. The over-35 and, even more likely, over-55 cohorts purchase state and local government debt. They were battered by all markets; they then subsequently watched the AAA Muni credit rating disappear due to the downgrading of the Muni bond insurers. They watched their funds freeze in certain investments. Moreover, they continue to be scared by the news flow from places like Harrisburg. Just as they fail to take advantage of favorable stock valuations, they also fail to purchase long-term tax-free bonds. We see the result in the pricing of tax-free Munis at levels that yield more than 100% of the duration-referenced Treasury bonds.
This pricing makes no sense unless either the income tax code of the US is going to be repealed or there is going to be a mass of defaults by thousands of the 90,000 Muni issuers. No one expects the former to occur. If anything, the tax rates are expected to rise. As to the second, the evidence is that the pricing is not about credit risk. We say that because the issues of federally backed housing-authority Munis, which are tax-free, currently trade at about the same yield as the duration-matched Treasury obligations. So there you have credit risk of the federal government on both sides of the comparison. One is tax-free and the other is taxable.
This Muni anomaly is not about credit risk. It is about PTFSD in the Muni sector. The AAA rating was the Muni buyer’s security blanket, just as primary-dealer status preservation was the security blanket for the banking system and the financial markets. Remember, the Fed had intervened to facilitate saving Countrywide and Bear Stearns; these were the first two casualties among the original 20 primary dealers. Casualty number three, Merrill Lynch, was merged; it did not fail to pay its obligations. Lehman was the fourth casualty and the PTFSD-inducing surprise.
We did not perform the detailed statistical work that Howard Simons evidenced in his research piece. We did not have to. He references the US Treasury term structure. We matched it against the tax-free Muni curve. One eyeball is all you need to reach a conclusion.
Munis are very cheap. They remain so because traumatized American, high-bracket, older-cohort bond buyers are afraid. Stocks are also cheap. Americans are scared of both sectors.
Foreigners are less scared. They are buying stocks and they are now buying US Munis at record levels, thanks to the introduction of the Build America Bond (BAB). This is a taxable form of a Muni. It was introduced in 2009 and has a federal subsidy attached to the interest payment. BABs issuance is gradually working to compress tax-free yields relative to taxable yields, and it has provided a security to the foreign buyer that is very attractive. US institutions are gradually recognizing the value here as well. We see it in our client base, where pension plans and foundations now use us to help them with BAB portfolio development.
Cumberland is bullish on the US stock market and expects it to close the “Lehman Gap.” That means a target of 1250-1300 on the S&P 500 index is possible before the market runs into strategic headwinds. We are also bullish on BABs and tax-free Munis. These two classes of securities are cheap relative to other bonds and cheap on an idiosyncratic valuation as well.
We thank Howard Simons and Jim Bianco for their help. We also note that the aggregate stock market measurement we cited is from the World Federation of Stock Exchanges. As for PTFSD, it takes time and treatment to heal. Any subsequent shock is magnified by the recent experience.
David R. Kotok, Chairman & Chief Investment Officer, Cumberland Advisors, www.cumber.com