The Lost Decade - Commentary & Strategy (October 2009)

7/31/2019 The Lost Decade - Commentary & Strategy (October 2009)

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bienvillecapital.com

QUARTERLY COMMENTARY & REVIEWOctober 2009

M. Cullen Thompson, CFAManaging Partner & Chief Investment [email protected]

The Lost Decade

Love affairs, as they say, dont end easily. Yet one

has to marvel at the unwavering obsession with US

equities. As many 401k participants will attest, the

decade of the 2000s has not been kind to investors,

particularly to those of the buy-and-hold variety. On

January 1, 2000, the S&P 500 stepped into the new

millennium at 1,469, nearly 40 percent higher than its

1,060 closing price on September 30, 2009.Accounting for dividends softens the damage, bringing

the cumulative loss to 14 percent. But the additional

yield is overwhelmed by the 28 percent rise in

inflation. All told, the S&P has trailed the CPI by a

stomach-churning 42 percent.

Secular bear markets are more common than most

investors believe, as even a cursory glance at the

following chart shows. Unlike today, the 16-year

stretch of negative real returns culminating in 1982 left

many investors disillusioned. Business Week

audaciously called for the demise of the asset class

with their often-ridiculed August 1979 cover story

The Death of Equities, believing that the growing

disenfranchisement with equities could no longer be

seen as something a stock market rallyhowever

strongwill check, given that negative real returns

had persisted for more than 10 years through market

rallies, business cycles, recession, recoveries and

booms. Resurrecting interest in US stocks would

require not only years of confidence building, but

also a massive promotional campaign to bring people

back to the market.

High inflation, interest rates and energy prices werethe affliction of the day. Lacking imagination, the

editors could not foresee the ensuing bull market

whereby share prices (and valuations) would be sent

firmly into orbit. Between 1982 and 1999, US stock

prices rose by a factor of thirteen, marking the most

remarkable run of annual increases in the history of

the American republic.

Despite the wealth destruction of 2008, no

promotional campaigns are necessary to reinvigorate

interest in equities in 2009. Sensing an opportunityfollowing the worst contraction in US stocks since

1931, investorsconditioned to buy the dipsappear

hell-bent on recovering their retirement-wrecking

losses. In doing so, they are scooping up shares with

little regard to valuations, prospective revenue growth,

the developing fiscal crisis or more generally the

-50

-40

-30

-20

-10

0

10

20

30

40

Jan-00 Jan-02 Jan-04 Jan-06 Jan-08

"Buy & Suffer " -S&P 500 Index vs. Inflation

Consumer Pr ice I nd ex (CPI ) S&P 500

Source: Bloomberg


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QUARTERLY COMMENTARY & REVIEW

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fallibility of policies of adding debt onto already

unsustainable levels of debt.

Persistence, we suppose, is the American way. But

prudence, we believe, would be better placed in the

investor psyche. For in no way did the trough in

equity prices this past March resemble the multi-

decade opportunity originating in 82, a time when

stock prices were low and their accompanying

dividends high.

Shortly after Business Weeks ill-timed article went to

press, a sort of macroeconomic tranquility fell over the

globea nearly three decade period of lower inflation

and interest rates, growth-inspiring demographics,

deregulation, globalization, as well as technological

advancement. The Great Moderation, it was later

called, a self-congratulatory term coined by central

bankers themselves. Echoing former Treasury

Secretary Andrew W. Mellon, who in 1928 claimed

that, we are no longer the victims of the vagaries of

business cycles. The Federal Reserve System is the

antidote for money contraction and shortage,

Greenspan, Bernanke, Geithner and Yellen, along with

their other FOMC committee members, ventured the

notion that it was their credibility and abundant

talents at manipulating interest rates that hadaccomplished what none of their predecessors had. If

central banking was a science, they had mastered it.

From now on, we would have the booms without the

busts. And with the road of never-ending prosperity

wide open, excessive leverage, sky-rocketing asset

prices and a little irrational exuberance were of no

material concern.

But Leverage, as James Grant, editor of the

eponymous financial newsletter has eloquently

described, is the Hamburger Helper of Finance. Itmakes a little capital go a long way, often much further

than it safely should.

In leading up to the current crisis, private sector

leverage went too far. And by socializing finance, the

authorities transferred many of the liabilities of the

private sector to the public balance sheet, and in doing

so, accelerated the possibility of a fiscal crisis.

Governments, as history has proven, get into debt

without any intention of ever getting out. Well aware

of this awkward fact, our founding fathers vowed to

prevent it. In a letter to James Madison in 1789,

Thomas Jefferson asked whether one generation of

men has the right to bind another, ultimately deciding

for himself that no generation can contract debts

greater than may be paid during the course of its own

existence.

Washington today operates under a different moral

compass. But should restraint soon find its way to

Capitol Hill and the current double-digit budget deficit

be reduced to a seemingly manageable 5.0 percent,

outstanding Treasury debt, now footing to 60 percent

of GDP, will continue its inexorable rise towards 100

percenta level which, in the words of Standard &

Poors, is incompatible with a triple-A rating. Given

that the majority of our deficit funding comes from

foreign investors, the US is in a precarious situation.

How long can we continue to rely on the kindness of

strangers?

Excessive leverage, whether in the public, private or

financial sector is the key ingredient for identifying an

economy underpinned by quicksandone that is

increasingly accident-prone and dependent on the

fickleness of confidence in order to stay afloat.

In their recent book, This Time is Different Kenneth

Rogoff, former Chief Economist at the IMF, and

Carmen Reinhart emphasize this point as they

chronicle Eight Centuries of Financial Folly, which also

serves as the subtitle. In the preface, the authors

highlight one common theme that preceded the vast

range of crises analyzed: excessive debt accumulation,

whether it be by government, banks, corporations, or

consumers is what often poses much greater systemic

risks than imagined.

Complicating the investment environment today are a

number of complex, interrelated and hard-to-predict

issues, specifically the tug-of-war between inflation


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versus deflation, rising unemployment, potentially

higher interest rates resulting from exploding public

debt, the forthcoming refinancing wave of both

residential and commercial real estate and the rapid

deleveraging of the American consumer, the de factoengine of growth for a highly imbalanced US and

global economy.

The threats of imminent economic collapse and the

failure of another major financial institution have

thankfully passed (largely as a result of the To Big to

Fail doctrine). But in guaranteeing so, the authorities

removed one form of systemic risk and introduced

another. Namely, they have threatened the credibility

and financial stability of the United States, as well as

the uncollateralized dollar it prints.

Benjamin Graham and David Dodd, godfathers of

value investing and authors of Security Analysis,

believed that since the future is unpredictable, a

margin a safety is required when putting capital at risk.

Buying an asset at a price below its intrinsic value

provides a natural defense against general uncertainty.

Both would likely blush at the premium multiples

presently attached to the vast majority of equities.

Predicting the Death of Equities in the US would be as

nonsensical now as it was in 1979. To be sure,

opportunities are selectively available now and will be

broadly so in the future. But as the previous charts

illustrate, equity prices do not rise unconditionally

from every starting point. And as those who paid

peak multiples in 1999 painfully learned, what you buy

(i.e. quality) and the price you pay for it (i.e. valuation)

matters. Today, the S&P is priced for perfection. But

what if the future delivers something short of it?

Portfolio Review & Strategy

Debt, we informed our clients earlier in the year,

is the new equity. If there was a silver-lining of the

credit crack-up of 08, it was the astonishingopportunities in highly dislocated fixed income

markets left in its wake. Investment grade bonds,

convertible bonds, TIPS and mortgage-back securities,

all sporting high yields and low prices, were in our

sights. As for US government bonds, we were short.

At 500 basis points over Treasuries, investment grade

corporate bonds were on offer at spreads not seen

since the Depression (the Great one that is), implying

default rates that, for all intents and purposes, were

simply unfathomable. Treasury Inflation-ProtectedSecurities were discounting multiple years of deflation

while converts, nearly annihilated in the forced

deleveraging of last year, were trading below their

straight bond equivalents (i.e. assigning no value to the

embedded option to convert into equity).

Equity-like returns with the security of a bonda

rarity in supposedly efficient capital marketswas our

motto. At the beginning of 2009, we decided, our

focus would be high in the capital structure.

On the opportunity, we were correctall sectors have

enjoyed double-digit gains. Investment grade bonds

snapped back to rationality, mortgage-backed

securities have rallied 20 percent, while convertible

bonds have gained over 30 percent.


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Our estimated time horizon, however, was admittedly

off. Expecting a multi-year opportunity, we were

rewarded in just a few months. Such flagrant

mispricings dont usually persist long, and nor should

they on the back of the most radical reflationarycampaign in modern history. Thank you for the

opportunity, we say to the Great Recession, its now

time to move on.

Within equities, we have been and remain largely

underweight, modestly hedged and globally-oriented.

Put simply, the rally off the March lows has gone too

far too fast, benefitting from increased risk appetite

that has driven an unprecedented expansion of P/E

multiples. Cyclical rallies in secular bear markets can

be frequent and pronounced, as even a passiveobserver of Japan over the last twenty years or the US

in the 1930s would note. Our long positions are high-

quality and largely exposed to secular themes,

specifically, emerging markets, Asia and energy.

Our hedged nature benefitted us considerably in the

first quarter of the year. As the S&P fell 25 percent,

bringing its peak-to-trough decline to nearly 60

percent, our portfolios were never down more thansingle-digits (and in many cases, were positive). This

preservation of capital allowed us to deploy assets

opportunistically. Yet our cautious positioning has

fortunately not detracted from overall portfolio

returns as equity markets began to recover in March,

thanks largely to manager and security selection, which

has been a tremendously positive contributor

throughout the year.

Indiscriminate selling in late 08 and early 09 led to

very favorable conditions for active management.

Heading into the year, we felt that many of our longer

term, core equity managers had enormous embedded

value in their portfolios. As it turns out, we were

correct. As of writing1

Over the course of the year 100 percent of our

managers and equity positions outperformed the

S&Pa perfect batting average that is certain to be

the exception rather than the ruleand did so by a

margin that was more than sufficient to offset our

modest hedge on the index, which was used to remove

some unwanted market directional risk (allowing us to

isolate more of our returns into the skill of ourmanagers).

, within domestic equities, our

two long-only managers appreciated by 30 percent and

51 percent, respectively. Our internationally-focused

allocations, representing the majority of our equity

exposure, performed equally as well (developed

international: +24 percent, Asia-specific: +40 percent

and emerging markets: +69 percent). Additionally, we

made two profitable tactical allocations to the energyspace (energy services: +62 percent and exploration &

production: +46 percent).

We maintain a position in gold, which we believe to be

an essential form of insurance in a highly-imbalanced

world. Appreciating 20 percent year-to-date, gold

remains, for the most part, inversely correlated to the

level of confidence in governments.

We are also still carrying healthy allocations to cash

the ultimate deflation hedgedespite the paltry

returns available. Our cash positions largely reflect

the lack of value in many asset classes and our belief

that better opportunities possibly lie ahead. Risk, as

always, is to be taken in a measured fashion and

balanced with the potential reward.

1October 20, 2009


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Although the recession may be over, the recovery has

been policy-inducedthe result of transitory

subsidies, stimulus and gimmicks. It was, to a large

extent, engineered in Washington. Organic, private

sector demand, the hallmark of sustainable economicexpansions, remains weak.

All recessions are not created equal. There are

business cycle recessions and balance sheet recessions.

The former are more common and the latter more

damaging in their severity and duration. The Great

Recession was a balance sheet recession. Higher

savings, less debt and lower consumption will be the

new reality, making it hard to envision the sustainable

vigor necessary to drive corporate profits enough to

justify todays lofty valuations.

Wisdom, it has been said, consists of the anticipation

of consequences. The consequences of intervention

(i.e. quantitative easing, double-digit fiscal deficits,

exploding sovereign debt, bailouts, guarantees and the

general socialization of risk) will be of the intended

and unintended kind. We will be anticipating both,

hopefully able to navigate what is certain to be an

uncertain world. Flexibility, therefore, remains our

primary advantage, firmly acknowledging that

deflationary aftershocks following a post-bubble creditcollapse are common and often lasts years, not

months. Investing, as PIMCOs Bill Gross recently

remarked, is no longer childs play.

Disclaimers

Bienville Capital Management, LLC. (Bienville) is an

SEC registered investment adviser with its principal

place of business in the State of New York. Bienville

and its representatives are in compliance with the

current notice filing requirements imposed upon

registered investment advisers by those states in which

Bienville maintains clients. Bienville may only transact

business in those states in which it is notice filed, or

qualifies for an exemption or exclusion from notice

filing requirements. This document is limited to the

dissemination of general information pertaining to its

investment advisory services. Any subsequent, direct

communication by Bienville with a prospective client

shall be conducted by a representative that is either

registered or qualifies for an exemption or exclusion

from registration in the state where the prospective

client resides. For information pertaining to theregistration status of Bienville, please contact Bienville

or refer to the Investment Adviser Public Disclosure

web site (www.adviserinfo.sec.gov).

This document is confidential, intended only for the

person to whom it has been provided, and under no

circumstance may be shown, transmitted or otherwise

provided to any person other than the authorized

recipient. While all information in this document is

believed to be accurate, the General Partner makes no

express warranty as to its completeness or accuracyand is not responsible for errors in the document.

This document contains general information that is

not suitable for everyone. The information contained

herein should not be construed as personalized

investment advice. The views expressed here are the

current opinions of the author and not necessarily

those of Bienville Capital Management. The authors

opinions are subject to change without notice. There

is no guarantee that the views and opinions expressed

in this document will come to pass. Investing in thestock market involves gains and losses and may not be

suitable for all investors. Information presented

herein is subject to change without notice and should

not be considered as a solicitation to buy or sell any

security.

Past performance may not be indicative of future

results and the performance of a specific individual

client account may vary substantially from the

foregoing general performance results. Therefore, no

current or prospective client should assume that futureperformance will be profitable or equal the foregoing

results. Furthermore, different types of investments

and management styles involve varying degrees of risk

and there can be no assurance that any investment or

investment style will be profitable. The performance

numbers presented herein for Bienvilles long strategy

are for informational purposes only and do not


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represent the performance of all client accounts. The

performance numbers are gross net of fees.

For additional information about Bienville, including

fees and services, send for our disclosure statement as

set forth on Form ADV from Bienville using the

contact information herein. Please read the disclosure

statement carefully before you invest or send money.

The Lost Decade - Commentary & Strategy (October 2009)

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