Ruminations

At the age of 24, I was a recent college graduate who was broke, unemployed, and with no contacts in the midst of the biggest recession since the beginning of the century. It was November 2008, almost two years after I broke my back playing college basketball which shattered my dreams to play professionally overseas, I talked a random stranger at Starbucks into giving me 100k to invest for him in the stock market…

It was the start of a very crazy and exciting career that landed me starting a Space company Litepulse and a Space Finance company Aurvandil. I don’t typically allow the public to see into the inner workings of my mind/business but today I wanted to share my 2010 Letter to the Investors from my investment company back then.

I do this for two reasons, the first is to show some of the causes that led to artificially low-interest rates that resulted in the massive excess that was 2021-2022 (along with other factors).

The second is to prove a point that it does not matter what the economic environment is, you can both raise capital and create excellent businesses. The capital market and fundraising are tight right now, however, some of the best times to start a business are in recessions/tight capital markets. There’s less competition, more access to talent, and far better valuations to deploy capital.

Looking back on this letter 15 years later most of the overall themes played out really well, I was wrong on the amplitude (depth from top to bottom of the index) of the pullback (which happened 3 months after this was written), but correct on the direction and issues of the plaguing the housing market which bottomed a couple of years later.

With that said, here is the letter. Enjoy…

The Stedman Group LLC

To the investors of The Stedman Group LLC:

As long as investors remain human, thus subject to greed, fear, pressure, doubt, and the entire range of human emotions, there will be money to be made by those who steel themselves to overcome emotion. As long as the human tendency to march in herds persists, there will be opportunities for containers that are unafraid to stand alone. -J. Ezra Merkin.

2009 is in the books. It was a year of extremes in both the economy and the markets, with panics and exuberances aplenty. The financial landscape of Wall Street has been altered in a way not seen in decades. Hundred billion dollar companies filed, were bought out for pennies on the dollar, and were subsidized by public money. When history looks back upon the subsequence period that preceded the “Great Recession” (as dubbed by the media) they will marvel at mankind’s willingness to partake in a “Wretched Excess,” as it is known by Buffet and Munger.

The index by which I measure performance is The S&P 500 index. This is arguably the most comprehensive index for US business, and thus the most typical benchmark for investments. The index itself finished 2009 up 23.45% after a monstrous 9-month run to finish the year. This type of run historically has only had one predecessor, which was the aftermath of the great collapse in 1929. Whether or not history repeats itself is a whole other matter, but with strong economic headwinds still persisting, it is an issue that needs to be looked at.

The Stedman Group investors finished up 46.96% after fees; a return of about twice that of the S&P 500 index. Even after a less-than-adequate second half of the year where performance dwindled, the roughly 47% finish is well above the self-professed goal of a 30% compound rate after fees. All things considered, the first year of investing has to be considered a success.

Outlook for 2010:

In the future I will not be providing written forecasts for the economy and the stock market, however, in light of recent events I feel obligated to explain my thesis for the current investments, which have to date, proven unsuccessful. So, I will provide a glimpse into my thinking on the economy, but for the sake of simplicity, I will keep each factor short and sweet. Each of the following are problems that when put together as a whole will produce serious consequences for both the market and the economy.

The underlying economic factors that started the recent events have not improved, even with the unprecedented government intervention. I consider the Mortgage Market for the past 5 years to be a “Wretched Excess” because, as Munger and Buffet define, “it produces wretched consequences. It’s irrational. If you mix raisins with turds, they are still turds.” Subprime, Option ARMs, and the subsequent CDOs and other financial products (which I will not dive into further because each would take an entire chapter to themselves) can all be considered turds. Originally it was these products that saturated the markets and created a ripple effect when the default rates started to rise substantially. The result was the effective nationalization of Fannie Mae, Freddy Mac, AIG, GM, and the “bailout” of hundreds of banks both large and small. This type of hurdle for the American economy to overcome would be large even if this were a typical recession; however the scope and breadth of the current economic situation I believe is not of your typical variety.

The home market has not bottomed and will not do so until the glut of foreclosures are absorbed into the market. Herein lies the problem. While originally confined to subprime mortgages and their like, recent foreclosures have risen dramatically across all spectrums, including the prime category, as a result of the massive layoffs by American companies over the last year. The government projects that 7.2 million jobs have been lost (more on this number later) and these people who have been laid off are starting to reach the end of their savings, which will result in more foreclosures into an already oversupplied system. On top of that, over 20% of all homeowners are underwater on their mortgages, resulting from the massive price declines in the past two years. These factors will contribute to reducing American consumer spending dramatically. The government has put in place tax credits and artificially suppressed interest rates in the yield curve at both ends to get buyers enticed to start purchasing. This will prove to be unsuccessful because, although it has created a short-term jump in buying after the measures have run out, buying will be dramatically reduced (as was the case in November before the tax credit was extended and expanded to entice more buyers). Historically the American consumer has made up 65% of GDP growth, in recent years however, this has been around 70-75%. As one can imagine, this will continue to be a dramatic drag on the economy as consumers increase their savings rates and deleverage their own balance sheets.

The commercial real estate market is headed for a large rollover of debt in the next 3 years. The underlying values of the property have declined along with rents. This is the same basic problem plaguing the residential housing market. Deals were done at the height of the market and are not going to be able to be refinanced. The vacancy is at 17% nationwide, which is the highest it has been in decades. This is another problem for the banking system because the primary component of small banks’ portfolios is largely comprised of commercial real estate. The resulting losses will have to be booked in the next 3 years. And considering the FDIC is already in the red from the last year, more governmental money will be required to help support the insurance fund that is supposed to guarantee the deposits of the nation.

The Government and the Federal Reserve have taken extreme actions in the last year and a half to help control and confine the credit crises. We will start with the Fed. They have pushed the benchmark rate down to 0-.25%; this is the lowest it can possibly go. Furthermore, they have been buying mortgage-backed securities and agency debt (mostly Fannie and Freddy). The Fed has used its Quantitative Easing program to push long-term rates down, which is why we have had mortgage rates under 5%. In recent months they have come out and said they plan on ending their QE program by the end of the 1st quarter. This along with emergency lending procedures they opened up during the height of the crises was the primary reason a complete meltdown was adverted (the Fed has closed these emergency-lending programs already). When the QE program is ended, the market will have to be able to make up for a lack of demand, which will be extremely difficult, thus driving yields higher and will also continue to suppress home buyers’ appetite. A “quasi-governmental” program, directed through Fannie and Freddy, will pick up some of the slack in demand. On Christmas Eve of ’09, the Government issued a blank check to cover the continuing obligations of the two entities and allowed them to increase their portfolios by over 100 billion each. This is in effect a wrap-around fix for the discontinued QE program. Thus the Government is still continuing to subsidize the market. The resulting consequences of this action will be discussed later on.

The Government deficit, which has ballooned in the last two years to over 1 trillion in each fiscal year, will become a large problem when it comes time to roll over debt. Which I will add, is going to start later this year. These deficits will not go down substantially in the near future, because as we have all seen, once the government has the money it is usually unwilling to let it go. Furthermore, the Government deficits do not include the amount in which they have guaranteed Fannie and Freddy, both of whose portfolios will be around 800 billion. Losses on these portfolios will be large considering that many of these mortgages are backed by those who are non-prime lendees. The deficits will not be an immediate problem, however, when Treasury sales become soft we will have a huge issue on our hands. When that happens the yields must go up to entice buyers. When the appetite of the world’s investors (not to mention the Fed, who has also been buying Treasures through the QE program) is sated, yields will start rising concurrently.

The unemployment number stands at 10%, as of this month. In all honestly, this is a statistical joke, and a cruel one at that. We are not having the massive layoffs as in the 1st and 2nd quarters, however, our economy is still losing jobs each month. The stated unemployment number differs from the actual number of people unemployed because people are dropping out of the workforce at a substantial rate. People who are not actively looking for work are excluded from the numbers, artificially reducing the numbers. A more conservative measure of underemployment is around 17% or so. Consequently, that extra 7% of people are not contributing to the national economy as they would if they had full-time paychecks. Remember, even if people have part-time jobs they still are not earning as they would in full-time jobs and when they go back to work full-time it will be at a lesser rate.

Banks and lending institutions are also in the process of deleveraging, which has been and will continue to restrict consumer credit even further. They must get toxic assets off their books, but in order to do this they must write them down, an action they have been unwilling to take in the quantities necessary to finish the process. Financial accounting rules and government regulators are actually helping this. Most notably, the Mark-to-Market rule, changed in mid-February, subsequently led to the massive rally. The Market- to-Market rule, when repealed, allowed institutions to carry assets on their books at cost rather than market value because there was no liquid market at the time. While the losses have not been booked, the asset’s value is far under the carrying value on the books. GMAC, the lending arm of GM, is a prime example of this. Last week they announced they were taking multiple billion-dollar write-downs on a portion of their mortgage asset portfolio because they are in the process of trying to sell them. They did not mark the asset prices at market value until they were forced to by attempting to sell them. It goes deeper than that, but that action is a tiny peak into the market for mortgage-backed securities, which are still below the carrying value on the books.

Small businesses are going to have to start hiring in order for job creation to commence, thus allowing American consumer spending to increase. This is a problem for two reasons. First, those same lending institutions that are deleveraging their balance sheets are drastically reducing credit to small businesses. The most current Fed Beige Book (the criteria used for making open market decisions), released today, continued to cite the tight credit markets in all parts of the country. Secondly, the government is further reducing the will to hire because of legislation being passed as we speak. Both the healthcare bill and the tax increases that are in the Capital right now are going to put more pressure on small businesses cost structures. Resulting in less hiring because the cost associated with having employees are going to increase. Bringing me back to my statement that unemployment and consumer spending will not abate for a while; this process will take years to finish playing out. Everything happening right now depends on continued governmental support. There is not a single major area in our economy where the Government has not acted as a crutch for the system. Which ultimately comes back to unemployment and the people. We are the ones who will pay for this crutch in the form of higher taxes, which will further reduce consumer spending. The major driver of our economy is in serious trouble, and thus the world’s economy as well. (China is not the answer, with 1/3rd the size of our economy and AMERICAN CONSUMERS being a huge part of their export-based economy; this will not be enough to push our economy to sustainability). These are the main problems facing our economy, there are however many more small ones that can also lead to impediments in the growth (enter Sovern wealth default and state default among other things) of the American economy and the Stock Market.

The aforementioned problems, and the ones that have gone unmentioned, will have stern repercussions for the Stock Market and Bond Market in general. I will focus on primarily the stock market because that is my preferred medium of investment. However, this analysis does apply to both. The Stock market has gone on a tear in recent months. Since the bottom (possibly temporary bottom, depending on how things play out) in March, the stock market has basically gone straight up. There have been some small retracements but nothing substantial by any means. This corresponding run-up has been historical, even when taking into account the panic selling at the bottom by investors in the last week or so. That alone is a reason to be wary of the market action. In the words of Warren B. Buffet, “Be fearful when others are greedy, and be greedy when others are fearful,” is excellent advice from the second richest man in America.

Consider this, in the past three months insiders’ transactions (those people who run the companies) have been extremely lopsided, with more sellers than buyers by a considerable margin. The vast majority have been selling their shares hand over fist. IPOs have been considerably weak in recent months, which along with all the secondaries by companies trying to raise cash, have substantially increased the total number of shares in the markets. (For those of will point out that some bankrupt companies get delisted by the market indices, thus reducing the number of shares outstanding, I just want to say for every company that is delisted another one takes its place). Venture Capital Investment companies are trying to push deals into the market at a fast clip because they are afraid the window of opportunity will close. Remember it is their job to buy low and sell high, so when they are pushing deals it usually means the market is “high.” Volume has continuously been declining for the last 7 months. Volume is a huge indicator of market movements. Low-volume movements are not sustainable and the resulting price swings are more dramatic, which makes overall moves more exaggerated. Bullish sentiment is the highest it has been since mid ’07. This shows that investors are complacent to an extreme (the VIX is another sign), almost as if the previous crises and subsequent problems never happened. The exact opposite was true during the March lows when everyone and their dogs were bearish, which I might add was the perfect time to buy. Hence Buffet’s memorable slogan was mentioned earlier. Furthermore, the P/E ratio on the S&P 500 is around 24, with the historical average falling around 16. Basically, the market is pricing in a recovery in profits and has not a single iota of risk to the fundamental economy going forward. The dollar carry trade, which has been a major driving factor of an inverse relationship between commodities, equities, foreign exchange, and the dollar value, will turn on a dime when the risk gets repriced into the market. Long term the dollar has plenty of problems that will need to be addressed but it will still serve as a safe haven in short-term volatility. There are many other technical indicators that also point to a more than mature market. All these indicators may not seem like much to go on, however to me, they are screaming “overvalued” and “unsustainable,” which taken together with the underlying fundamentals of the American Consumer points to a substantial retracement and potentially a revisit of our lows. Whether or not these come to pass is for history to decide, but I consider a net long position in the market right now very troubling indeed.

Against the grain,

Karl Stedman Jr.

Per ardua ad astra