A question I’m always asked as editor of The Independent Adviser for Vanguard Investors is why don’t I don’t just recommend Vanguard’s index funds for my Model Portfolio?
The answer is simple. As the chairman of the nation’s largest independent organization of Vanguard investors, my goal is to help you get the most out of Vanguard funds, and there is no disputing that Vanguard’s actively managed funds outperform their index funds.
Two industry legends that outperform the relevant indexes time and time again are none other than Selected Value’s Jim Barrow and Mark Giambrone. Their performance as fund managers over the years has been strong and stable, and frankly, I trust them with my money, and so should you.
Recently, I got a rare chance to interview both of them and see what they’re doing to protect themselves from the volatility in the stock market. Both agree that the current crisis on Wall Street simply needs time to simple run its course. And both are convinced that after it does, there will be some uncovered gems worth buying before they rebound!
What to Do Now: Simply Wait Out the StormDW: Jim, the last time we spoke, you were not overly concerned about the housing “crisis.” It seems to have pushed a lot of people into fear mode.
JB: This boom took 10 or 15 years to grow, so it’ll take longer than a year to clean out. I have seen this happen before. It happened here in the early ’90s, and you go through it and eventually work your way out of it.
The bigger problem, Dan, is not the housing market. The bigger problem is that these banks and brokerage firms have to ‘fess up to their bad mortgage-backed paper and write it off and then go back and recapitalize their balance sheets, they are also going to right-size their assets–which means that they are going to get rid of loans. That means it’s going to be increasingly difficult to acquire loans.
Now, the average corporation has a pretty good-looking balance sheet, so it’s not going to make much of a difference to them, but it’s going to affect the marginal user of credit (private equity capital and hedge funds), and they may not be able to get a loan.
DW: And that’s causing the sell-off?
JB: A lot of these bank loans are going to investment pools of one sort or another. So, you go to the bank to renew your commitment, and they say, “Sorry, Dan, we can’t do that anymore, you’re going to have to sell some of the stuff that you’ve got,” and they’ve been running on leverage all of the time anyway–well, you’re going to sell some of the stuff you own in order to pay them back. That’s kind of what’s going on right now. They are selling across the board, because if I call in your loan and you’re a long-short guy, which means you have to cover your shorts and sell your longs. And most of these guys will leverage two or three or four or five–pick a number–times.
DW: But buying in his shorts is going to push prices up while selling longs pushes prices down� is that necessarily a bad thing?
JB: No, not necessarily. But there will be some long-only guys who can’t keep their loans out–they’re the guys who do private capital, and what they’re doing is borrowing short and lending long in some fashion. You can get kind of sideways in these transactions. We have seen some minor and some major buyout deals absolutely collapse because they can’t raise the money. And we’re not seeing any new ones start!
DW: All right, so you take the buyout factor out of the equation, but we’re still talking about an economy where people continue to need to buy computers and cars and eventually build more houses.
JB: I’m not saying it’s the end of the world.
It affects the marginal borrower, who I think is really not necessarily the consumer or the corporation. The last time we talked, I made a comment that I thought that some of these developing countries, their markets, looked like bubbles to us.
Hong Kong and Singapore and Malaysia, etc. are all down 15%, 16%, 17% year-to-date versus say 8% for the Dow Jones Industrials.
So those markets are getting corrected, and my suspicion is part of it is because you have what is commonly called a “credit correction” on the way.
MG: The only thing I would add to that is: If the Fed is lowering rates, doesn’t that solve the problem? It’s not the price of credit, it’s the availability of credit that’s having a major impact on the markets.
JB: Dropping rates is a pretty blunt instrument. It’s not like a scalpel to solve a specific problem; it just kind of pummels everything one way or the other. If you look at the shape of the yield curve, and nobody talks about this much, but the shape of it is pretty interesting. At the long end, you’re over 4%, and at the short end, you’re below 2%–that’s a pretty good yield curve!
DW: Mark, doesn’t the Fed lowering rates help the banks, because it gives them the opportunity to borrow lower and loan high? This might be a good way to help repair some of that balance-sheet problem, no?
MG: Dan, we don’t disagree with that. There’s no question that the steep yield curve increases the margin on lending. But when you’re not doing a whole lot of lending, having that margin there doesn’t necessarily help you, because of the need for capital. They’re concerned about their ratings, they’re concerned about what’s already on their books. So yes, that will help; it is helping, but it’s going to take a long time to really pull through.
JB: One of the things that fascinates us is that usually Wall Street creates products and sells them to Main Street, and then Main Street has trouble dealing with them. In this case, Wall Street created the product and kept it all on their own books. It’s kind of like me going out and getting somebody to fake a painting and then liking it so much I put it over my mantelpiece.
DW: So where do we come out on this thing?
JB: Time gets you out of it. It just takes a while, and the markets are having significant difficulty right now.
DW: Mark, you raised the “R” word awhile back. Are we going into a recession?
MG: I think we are in a recession, depending on what area of the market you want to talk about. Clearly housing, lending, we’re there.
Are we in a slowdown? Yes. Are earnings going down? Yes. Are we in a credit cycle? Yes. Is unemployment going to go up? Yes. All of these things are true, and I guess those are all consequences of a slowdown.
Whether that means we actually have negative GDP growth for two quarters or not to me is irrelevant. It’s just one of those things where it takes time to get through, and I think the market’s gyrations right now are related to the fact that it’s very difficult to figure out what inning we’re in.
JB: Dan, you’ve been doing this a long time, and you know that in most cases you only know you’re in a recession after you’ve been in it for a while. And what happens is they revise the numbers down two or three times and say, “You remember back in January? Well, we were in a recession then!”
In 2009, if we’re all still alive, we’ll be talking about what happened in early 2008, and we’ll know for sure then! At this point, we’re still speculating. But it feels like there’s a recession.
The reason we’re seeing so much volatility and, for the moment, mainly losses in stocks can be attributed in large measure to the fact that investors appear to be simply giving up on risk. They’re going for the safety, security and long-term lack of any appeal whatsoever of Treasury bonds–all of which make stocks, to my way of thinking, look a whole lot less risky than they did even a few months ago.
DW: OK, bottom-line-it for me: What happens this year?
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