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THE YEAR ABOUT TO END HAS BEEN, if nothing else, a learning experience for anyone participating in financial markets as well as one who's covered them. Herewith some of the valuable lessons gleaned from tumultuous 2009.
Valuations matter most at market extremes. When prices have collapsed, risk is the lowest and rewards potentially are the greatest. That's so logical, which is why it flies in the face of human nature. Prices wouldn't be depressed if people weren't panicking.
Yet if you could keep your head while all others were losing theirs, you could have been buying at the lows in early 2009.
Warren Buffett espoused purchasing stocks in November 2008 in a New York Times op-ed piece and his Berkshire Hathaway (BRKA) later took an equity stake in Goldman Sachs (GS.) Although the market already was down nearly 40% in eight months, it would fall more than 20% before finding a bottom in March. And Goldman common would fall nearly by half from the time of Berkshire's investment. (Of course, Goldman stock has come roaring back and is half again what it fetched when Buffett bought -- not including the fat yield that Berkshire gets.)
Near the time of the lows, even President Obama was saying stocks represented a good value, although he transparently was trying to talk up the market and investors' confidence. But it was Jeremy Grantham, the "G" in GMO, the institutional money manager, who last March unequivocally advocated investors put some of their piles of cash to work in an aptly named article, "Reinvesting When Terrified."
The Standard & Poor's 500 was worth 900, he wrote then, or 30% above where it stood, around 700. And Grantham thought there was a 50-50 chance the index could cross 600, his seven-year expected annual returns were in the 10%-13% -- in contrast with a year earlier when he reckoned they were negative at the market's peak.
Of course, that was just before the S&P's bottom around 670, from where it has catapulted 60%. Nobody catches the low, Grantham emphasized in March. In June 1933, the S&P was up 105%, long before banks stopped failing or unemployment peaked, he pointed out.
And as in 1933, monetary policy turned aggressively expansionary in March when the Federal Reserve announced it would purchase Treasury, agency and mortgage-backed securities totaling over $1.5 trillion to bring down long-term interest rates (its short-term rate target already having been reduced to near zero.)
That underscored the lesson from Milton Friedman years ago that, during the 1930s, the Fed's purchases of government securities were effective in countering the Depression -- when they were undertaken in sufficient quantities. (And it contradicted Henry Ford's assertion that history is more or less bunk.)
At the peak of the technology bubble in 1999, Grantham was equally adamant about the overvaluation of stocks. Instead, he switched into Treasury Inflation Protected Securities, which then offered extraordinarily high real (adjusted for inflation) yields of more than 3%. In the 10 years ended Nov. 30, TIPS returned 7.84% per annum versus minus 0.57% per year for the S&P 500 over that span. In dollar terms, you would have more than doubled your money in TIPS over those 10 years instead of seeing it shrink during that time.
Which brings up another lesson of 2009: Buying bonds with low yields is risky, even if they're "riskless" government securities. And buying bonds with super-high yields is safer even if they're junk.
With junk bonds then yielding more than 20% and investment-grade corporate bonds yielding in the double digits, these fixed-income securities provided the near certainty of equity-like returns with the lesser risk of debt securities. But a year ago, investors were fleeing such opportunities in favor of the "safe" harbor of Treasury securities, which were yielding just over 2% for the benchmark 10-year note.
The supposedly riskier investment-grade corporates returned 21% for the first 11 months of the year while junk shot up 50%. The safe Treasury alternative was down 5% over the period.
At this point, neither stocks nor investment-grade corporates nor junk bonds are screamingly cheap. Equities have priced in strong earnings gains for 2010 while credit-market spreads have shrunk sharply. Foreign markets, to which U.S. investors have been flocking in large part because of the falling dollar, no longer have currency translation as an advantage now that the greenback appears headed higher. The only thing that hasn't changed is that cash yields virtually zero.
So what lessons are ahead for 2010?
The Federal Reserve is widely expected to begin tightening monetary policy, which may mean relearning the lessons of 1937, when reversing easy money led to the second down-leg of the Depression. Meantime, risk perceptions, as encompassed in the VIX, have continued to fall. That implies a large level of complacency. In which case, cash -- the worst asset class of 2009 -- might end up the winner of 2010.
Return of capital could trump return on capital, as Will Rogers observed during the 1930s. That may be a painful lesson to learn.
Comments: randall.forsyth@barrons.com
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