Robert Arnott: Lessons from the “Naughties”

Wednesday, March 3rd, 2010

By Robert Arnott and John West - Research Affiliates

ROBERT ARNOTT, Chairman and Founder of Research Affiliates, LLC.

JOHN WEST, CFA, Director, Product Specialist of Research Affiliates, LLC.

Last month, we examined the Lost Decade and learned that much of the pain of the past 10 years was caused by an overreliance on the equity risk premium and the corrosive effect of capitalization weighting our equity holdings. Simply bypassing these two practices would have delivered respectable 7–8% annual returns. But past is not prologue. History is littered with the folly of building yesterday’s army to fight tomorrow’s war.

In this issue we apply the lessons of the recent Lost Decade to current market conditions. From an asset allocation perspective, the outlook for the ubiquitous 60/40 blend remains bleak. Unfortunately, moving away from this standard mix to a broader toolkit of risk exposures is likely to be less profitable than it was in the past decade as yields from diversifiers like REITs, TIPS, and emerging market bonds are well below the levels of 10 years ago. The key to better returns will be to respond tactically to the shifting spectrum of opportunity, especially expanding and contracting one’s overall risk budget. This approach, combined with “better beta” choices like the Fundamental Index® concept (which currently sports an unusually deep discount, relative to capitalization weighting), should help us to achieve our targeted returns in what—we shudder to suggest—is likely to be another tough slog for investors.

Busting Out The Crystal Ball

Naive mean reversion would indicate that 10 lean years for the 60/40 blend (60% S&P 500/40% BarCap Aggregate) ought to be followed by a decade of relatively strong results, especially when the recent lean years delivered the first ever decade of negative real returns! Of course, this assertion can only be verified with a perfectly tuned crystal ball.

While we take great pride in our asset class forecasting, we unfortunately don’t have such a device buried in our research department.[1] But we can reasonably project likely future asset class returns by starting with their key Building Blocks. The long-term return on any investment can be broken down into income, growth in income, and changes in valuation levels. Table 1 illustrates these components, save for changes in valuations levels (more on that later), for the S&P 500 and BarCap Aggregate Bond Index as of December 31, 1999, and December 31, 2009.

Let’s start with equities because we spent most of last month’s issue of Fundamentals on their Lost Decade. The dividend yield on the S&P 500 was 2.1% as of December 31, 2009.True, that’s almost double the rate at the end of the 1990s, but it’s still puny relative to a long-term average of 4.5% since 1900. If we add a historic growth rate to those dividends, we arrive at an annualized real long-term expected return of 3.3% for stocks, assuming no change in valuations. Clearly, 10 years of poor returns hasn’t materially impacted expected future returns. As some wags have suggested, the Tech bubble discounted not only future growth but also growth in the hereafter.

On the bond side, the current yield to maturity is an excellent predictor of future long-term returns. Accordingly, bonds helped the 60/40 portfolio in the Lost Decade as they started with a yield of over 7%. Today the yield is about half as large. Backing out today’s breakeven rate,[2] we see a core bond portfolio can be reasonably expected to achieve only an annualized 1.8% real return.

So, a reasonable expectation for a standard 60% stock and 40% bond mix over the next 10 years is a real return of 2–3% per year, again assuming no change in valuations. Yikes! The Lost Decade has most assuredly not paved the way for easy times in the years ahead. We’re still in a low return environment. This is a commonplace observation but most observers refer to low returns relative to the 1980s and 1990s, not the last decade.

The Impact Of Valuations—The BIG Wild Card

But valuations do change and have large multiplier effects on 10-year returns from asset classes, especially stocks. Consider that during the Naughties a rise in dividend yields from 1.1% to 2.1% implies a 48% drop in the value that the market was willing to pay for each dollar of dividends. That works out to a 6.5% annualized drop in valuation multiples. If we examine Table 1, we find that a valuation change of 6.5% pulls our annualized real return down from 2.3% to –4.2%. What was the actual result? A whole lot closer to the latter: –3.6%!

The annualized contribution of changing valuations to equity returns has ranged from +11% to –7% over the past six decades. So where are we today in the stock market? Figure 1 shows the performance of the Shiller P/E ratio over time. The Mother of All Recoveries has pushed equity valuations, marginally cheap in a historical context back in February 2009, back into the low 20s, a 25% premium to the long-term average.

Source: Research Affiliates based on data from Robert Shiller

As you can see in Figure 1, equities traded at the same P/E ratios as they did in early January 2010 in four distinct time periods (highlighted): 1928–1930, 1936–1937, much of the 1960s, and 1992–1995. Table 2 shows the subsequent average 10-year equity returns, inflation, and ending P/E ratios from each of these periods. Not surprisingly, the subsequent 10 years after 1928–1930 (even to those who slept through American history classes) showed negative nominal returns and deflation due to the Great Depression. The 10-year periods following 1936–1937 and the 1960s showed average annual inflation in the 4% range, well higher than we’ve seen in the past 25 years. With equity P/E ratios contracting into the 14–15 range, against a headwind of inflation, stock investors suffered skinny real returns of 1.5–2.5%. Only following the early 1990s did 10-year returns bump into double digits, as low inflation and rising valuation multiples allowed the S&P 500 to average 10.6% per annum, gains that were subsequently lost.

If we believe in higher long-term inflation over the next decade,[3] then equity valuations are likely to contract, meaning our Building Blocks return forecast for stocks and bonds may be too high. Stocks will produce less due to the downward pressure on valuation multiples, while higher inflation eats into today’s skinny nominal bond yields. So, one lesson of the Lost Decade is likely to hold true—an equity-centric mix of mainstream stocks and bonds is likely to disappoint. Again. Net of inflation, it could even be worse than the past 10 years.

Diversification And Alternative Assets: With No Fat Pitch, Think Tactical

A key tonic to the past 10 years was a more diversified, less equity-centric approach. A risk premium over government bonds isn’t restricted to equities; plenty of assets offer premiums in line with stocks and occasionally higher. In the last issue we used the 16-asset class portfolio[4] to illustrate the benefits of diversifying across a wider spectrum of asset classes. For the decade 2000–2009, this more-diversified approach achieved an annualized return of 6.8%, a 450 bps premium over 60/40. Abandon cap weight for stocks and the return jumps to 8.5%, nearly matching most investors’ targeted returns.

Looking forward, the outlook is not as “attractive” as it was in 2000. Today, yields on most of these diversifying assets are well off the rich premium levels at the turn of the century. Back then, NASDAQ-induced neglect led to a whole spectrum of alternative asset classes, favorably priced for attractive long-term returns. Today, we aren’t so lucky, as many off-the-beaten path categories sport rock bottom yields (and, therefore, low forward-looking returns). Figure 2 provides a quick snapshot of “Then Versus Now” in four asset classes: REITs, TIPS, emerging market bonds, and high-yield bonds.

Emerging markets bonds, REITs, and TIPS offer half of their Y2K yields. Even high-yield bonds, whose 1999 yields were pushed down due to heavy issuance by adored tech and telecom players, show significantly lower yields today. The fat pitch of diversification into risk premiums beyond mainstream stocks and bonds is largely gone.

So what to do? Manage the asset mix! Vitally important in this exercise is to shift risk postures. Too often asset allocation programs are governed by a relatively constant risk tolerance, say on par with a 60/40 stock/bond mix. This approach encourages swapping one risky asset class out for another (e.g., non-U.S. developed stocks for emerging markets stocks, REITs for U.S. stocks, etc.). But in the current environment, when all asset classes are rich, shouldn’t we consider a more conservative posture? This approach isn’t market timing but risk budgeting. We choose to take long-term risk when risk-bearing is likely to be rewarded, and a conservative, well-diversified posture when it is not. Rich forward-looking risk premiums typically prevail when investors are terrified, as they were in early 2009. As Warren Buffett suggests, we should be “greedy when others are fearful and fearful when others are greedy.”

Out-of-mainstream markets can still add value if we use them tactically and opportunistically. Inevitably, investors sell the assets they least understand when times get rocky, and buy them when conditions are calm. Thus, diversification can still be powerful, but only if we practice diligent tactical asset allocation.

Outlook for Equities? Depends On Your Index!

Stocks were terribly disappointing during the Naughties, but the results of the Fundamental Index approach (and, for that matter, equal weighting) illustrate that the shortfall was largely attributable to the cap-weighted construction of traditional indexes. The destruction of capitalization weighting wasn’t restricted to the two bookend years as evidenced in Table 3. A global, all-country Fundamental Index (FTSE RAFI® All World 3000) portfolio beat the representative global, all-country cap-weighted portfolio (MSCI ACWI) 9 years out of 10, falling short by a scant 30 bps in 2008. Even equal weighting, the most naIve of all price-indifferent approaches, managed to win by 600 bps per annum and did so consistently (8 years out of 10).

Of course, yesterday’s winners typically become tomorrow’s laggards. However, a comparison of current valuation discounts for Fundamental Index strategies versus cap-weighted ones indicates that avoiding the negative alpha of capitalization weighting is likely to still be profitable at today’s valuation levels. Previously, we noted that when RAFI US Large trades at a price/book ratio 27% or more “cheaper” to the S&P 500, the odds are good for subsequent outperformance—in the United States, the RAFI portfolio beats the S&P 500 in over 80% of subsequent three-year periods, with an average of 3.6% of additional return.[5]

So where does this discount stand today? Despite achieving in 2009 its second-best year ever of relative outperformance, the FTSE RAFI US 1000 still trades at a discount of 48% to the S&P 500. Similar discounts can be had elsewhere, including 38% for a global all-country application as evidenced in Table 4. These approach the historical peak discounts seen at the top of the tech bubble in early 2000. It’s not realistic to expect another 10 years of 600–700 bps per annum return drag from capitalization weighting. Nonetheless, given today’s discount levels, we expect continued sizable gains from noncap-weighted indexes and, therefore, continued benefits from using a Fundamental Index approach.

Conclusion

“Lost and Found” will not describe investment results for the first two decades of this millennium, as sizable real returns will prove to be difficult for the second 10-year stretch in a row. Most investors will fall short of their goals, as almost all asset classes—whether mainstream or alternatives—are priced richly relative to historical norms. But odds can be tilted back in our favor by tactically altering our portfolio risk based on measures as simple as yields and yield spreads. The most successful investors are those with the discipline to shun risk when the markets seem tranquil, and the fortitude to seek risk when others are terrified. The best path to future success marries risk management—tactical asset allocation—with a more efficient beta like the Fundamental Index methodology and a full toolkit of alternative markets.

Endnotes

1. Ironically, many of our turn-of-the-century predictions proved remarkably—and sadly—prescient. Early drafts of “The Death of the Risk Premium” (published in early 2001) were circulated as early as February 2000. Before the top! But, even a good crystal ball doesn’t assure success with clients. The mid-decade bull market caused some shorter-term investors to bail out of asset allocation programs, despite their eventual reliability over the full decade. Many paths can be taken to achieve a spot-on 10-year forecast. Successfully managing expectations is often harder than successfully managing assets!

2. Admittedly, breakeven rates are a poor predictor of future inflation, as they can be influenced by many things. In 2000, the relative newness of TIPS and the tech bubble allowed TIPS yields to briefly cross 4%. On the flip side, the liquidity-based sell-off in the fall of 2008 disproportionately hurt TIPS vs. nominal Treasuries.

3. See “3-D Hurricane Force Headwind,” Fundamentals, November 2009. http://www.rallc.com/ideas/pdf/Fundamentals_200911.pdf Incidentally, this longer-term near inevitability of inflation probably isn’t going to be an issue shorter term—next 12–24 months—as a weak recovery and falling rents will put pressure on CPI figures. But on a 10-year outlook (the minimum planning horizon for institutional investors and most retirement programs), our bet is on higher inflation. Perhaps even far higher.

4. The equally weighted portfolio comprises the following 16 indexes, rebalanced monthly: ML US Corporate & Government 1–3 Year; LB US Aggregate Bond TR; LB US Treasury Long TR; LB US Long Credit TR; LB US Corporate High Yield TR; Credit Suisse Leveraged Loan; JPM EMBI + Composite TR; JPM ELMI + Composite; ML Convertible Bonds All Qualities; LB Global Inflation Linked US TIPS TR; FTSE NAREIT All REITs TR; DJ AIG Commodity TR; S&P 500 TR; MSCI Emerging Markets TR; MSCI EAFE TR; Russell 2000 TR.

5 .“Discounts and Relative Performance,” Fundamentals, February 2009. http://researchaffiliates.com/ideas/pdf/Fundamentals_200902.pdf

Tags: Assertion, Asset Allocation, Capitalization, Cfa, Corrosive Effect, Crystal Ball, Current Market, Director Product, Emerging Market Bonds, Equity Holdings, Equity Risk Premium, Folly, Lean Years, Mean Reversion, Naughties, Product Specialist, Reits, Research Affiliates, Risk Exposures, Robert Arnott
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Jeremy Grantham: “Fair value on the S&P is 860″

Tuesday, October 27th, 2009

Jeremy Grantham has become a familiar and very popular face on this site. For those treasuring his insight, wisdom and prescient calls, the co-founder and chief investment strategist of Boston-based GMO has just published the October edition of his quarterly newsletter entitled “Just desserts and markets being silly again”.

Before quoting from the report, Grantham recently put matters into perspective in a Kiplinger article, saying: “The recent rally has been very speculative, favoring risky assets over the past few months. I’m sorry if you missed investing at the market’s March lows, but don’t compound the damage to your portfolio by chasing gains in risky assets. We’re at the beginning of a seven-year period of lean returns. You should only be buying the highest-quality blue-chip com­panies, where valuations are most attractive.”

Here are a few excerpts from the Grantham’s newsletter.

“Corporate ex-financials profit margins remain above average and, if I am right about the coming seven lean years, we will soon enough look back nostalgically at such high profits. Price/earnings ratios, adjusted for even normal margins, are also significantly above fair value after the rally. Fair value on the S&P is now about 860 (fair value has declined steadily as the accounting smoke clears from the wreckage and there are still, perhaps, some smoldering embers). This places today’s market (October 19) at almost 25% overpriced, and on a seven-year horizon would move our normal forecast of 5.7% real down by more than 3% a year. Doesn’t it seem odd that we would be measurably overpriced once again, given that we face a seven-year future that almost everyone agrees will be tougher than normal?

“Price … does matter eventually, and what will stop this market (my blind guess is in the first few months of next year) is a combination of two factors. First, the disappointing economic and financial data that will begin to show the intractably long-term nature of some of our problems, particularly pressure on profit margins as the quick fix of short-term labor cuts fades away. Second, the slow gravitational pull of value as US stocks reach +30-35% overpricing in the face of an extended difficult environment.

“It is hard for me to see what will stop the charge to risk-taking this year. With the near universality of the feeling of being left behind in reinvesting, it is nerve-wracking for us prudent investors to contemplate the odds of the market rushing past my earlier prediction of 1,100. It can certainly happen. Conversely, I have some modest hopes for a collective sensible resistance to the current Fed plot to have us all borrow and speculate again. I would still guess (a well-informed guess, I hope) that before next year is out, the market will drop painfully from current levels. ‘Painfully’ is arbitrarily deemed by me to start at -15%. My guess, though, is that the US market will drop below fair value, which is a 22% decline (from the S&P 500 level of 1,098 on October 19).

“Unlike the really tough bears, though, I see no need for a new low. I think the history books will be happy enough with the 666 of last February.”

Click here for the full report on Grantham’s reasoning for his cautious stance.

Source: Jeremy Grantham, GMO, October 2009.

Tags: Chief Investment Strategist, Co Founder, Desserts, Excerpts, Gmo, Guess, Horizon, Jeremy Grantham, Lean Years, Lows, October 19, Panies, Price Earnings Ratios, Profit Margins, Quarterly Newsletter, Rally, Risky Assets, S Market, Valuations, Wreckage
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Jeremy Grantham’s Morningstar Interview (5/28/09)

Sunday, June 7th, 2009

Jeremy Grantham, Chief Investment Officer, and founder of $150-billion Boston-based asset manager, GMO gives Morningstar an eloquent and quietly gripping interview. As usual, the super-modest, irrepressibly shy, Grantham, struggles to look up at Morningstar’s Pat Dorsey, and for that matter the camera. What comes through instead is the soft-spoken, and truly understated genius, known for his prescient calls on the market.

These are not to be missed.

Below are the videos of Jeremy Grantham as he was interviewed by Morningstar:

Part 1:

What to do if you missed the rally, and its durability.

http://www.morningstar.com/cover/videocenter.aspx?id=295077

Part II. Quality stocks will trump junk.

http://www.morningstar.com/cover/videocenter.aspx?id=295076

Part III: Seven lean years will follow…

http://www.morningstar.com/cover/videocenter.aspx?id=295072

Part IV: Growth stocks simply do not beat value stocks;
Fast growing countries do not necessarily outperform slow growing countries;
Top line growth almost does not matter.
Value matters in everything.

http://www.morningstar.com/cover/videocenter.aspx?id=295075

Part V. Grantham’s greatest concern is for inflation

http://www.morningstar.com/cover/videocenter.aspx?id=295073

Tags: Asset Manager, Boston, Cambria, Chief Investment Officer, Countries, Durability, Font Definitions, Font Format, Genius, Gmo, Growth Stocks, inflation, Jeremy Grantham, Lean Years, Morningstar, Mso, Orphan, Panose, Pat Dorsey, Pitch, Props, Quality Stocks, Rally, Serif, Style Definitions, Style Type, Text Decoration, Theme Font, Times New Roman, Value Matters, Value Stocks, Videos
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Jeremy Grantham: The last hurrah and seven lean years

Thursday, May 7th, 2009

Jeremy Grantham’s keenly awaited quarterly newsletter, entitled “The last hurrah and seven lean years”, has just been published. Grantham, who co-founded Boston-based GMO in 1977, covers a lot of thought-provoking ground in this letter, but focuses mostly on where to invest now.

The widely-respected Grantham’s newsletter is must-read material. The first few paragraphs are published below and a link to the full article is provided at the bottom of the post.

“First, let me lament the loss of near certainties in investing. The financial and economic collapse that I described as ‘the most widely predicted surprise in the history of finance’ about 18 months ago is behind us. More precisely, we believed that bubbles had formed in global profit margins, risk premiums, and U.S. and U.K. housing prices, and that all three were ‘near certainties’ to break, with severe consequences for the economic and financial system. All have thoroughly burst and are in their over correction phase with the single exception of U.K. house prices, which I’m confident will do their duty. Normally there are, of course, no near certainties in investing.

“Life is not meant to be that easy. Asset allocators have been blessed in the last 10 years with a large collection of extraordinary outliers. As my favorite quote by Mandelbrot (1983) says, ‘Even though economics is a very old subject, it has not truly come to grips with the main difficulty, which is the inordinate practical importance of a few extreme events.’ If this last 10 years did not prove him right, nothing will.

“Since 1988, we have been offered 8 or 10 2-sigma events. (A 2-sigma event is our definition of an important bubble or bust.) All of these events were bubbles, and all behaved themselves by bursting. Now, sadly, there are probably none.

“Government bonds are the one serious candidate. In our opinion, they are badly overpriced but probably not by enough to justify the bubble title. Global equity markets are still cheap, but in major markets are nowhere near 2-sigma, 40-year bust levels. Some smallscale 2-sigma bargains may exist in the fi xed income markets in rate differentials, but need skillful analysis and knowledge to disentangle from value traps. And, they are a very far cry from, say, the opportunities offered by buying credit default swaps at a handful of basis points on overleveraged financials in early 2007. So, all in all, welcome back to the age of guesswork.”

Click here for the full report.

Source: Jeremy Grantham, GMO, May 2009.

Tags: Asset Allocators, Bubb, Bubbles, Certainties, Correction Phase, Economic Collapse, Extreme Events, Favorite Quote, Gmo, Government Bonds, House Prices, Jeremy Grantham, Lament, Lean Years, Mandelbrot, Outliers, Paragraphs, Profit Margins, Quarterly Newsletter, Risk Premiums
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Prem Watsa: 2008 Letter to Shareholders

Tuesday, March 10th, 2009

Prem Watsa, Chairman and CEO, Fairfax Financial, one of Canada’s most successful investors, and often compared to Warren Buffett, has been vindicated with blockbuster returns arising from the company’s investments in 2008. Below are excerpts from his letter to shareholders for 2008, where Mr. Watsa discusses his observations of the year that has past and his outlook.

The letter opens with Watsa describing the results of the vindicating year:

Since we began 23 years ago, book value has compounded by 25% while our common stock price has followed at 23% per year. The last two years have made up significantly for the biblical seven lean years that you have suffered. In the seven lean years (1999-2005),we made no money on a cumulative basis. In the three years since (2006-2008), we have earned $2.8 billion after tax and book value per share has more than doubled. While we are pleased that our forecast of “the seven lean years are over” did come true, we much prefer the Noah principle, “Forecasting doesn’t count, building an ark does”!

On Page 5, the company’s moves in the market are described in some detail:

In November of 2008, after the stock markets had dropped 50% from their highs, we decided to remove the equity hedges on our portfolio investments. Also, as the yield on long (30-year) U.S. Treasuries began to drop below 3%, we sold almost all our U.S. Treasuries (at year-end we had only $985 million left, compared to $6.4 billion on December 31, 2007), having realized net gains of $583 million in 2008 on sales of U.S. Treasuries. Both the equity hedges and the U.S. Treasuries have done an outstanding job in protecting our capital. Our U.S. Treasury bond position was to a large extent replaced by $4.1 billion in U.S. state, municipal and other  tax-exempt bonds (of which $3.6 billion carry a Berkshire Hathaway guarantee) with an average yield (at purchase) of approximately 5.79% per annum. During the fourth quarter of 2008, we also increased our cash and short term investments by $752 million and invested an additional $2.3 billion in common stocks. The annualized pre-tax equivalent interest and dividend income has increased significantly for our company by virtue of our significant holdings of tax-exempt bonds and as we have taken advantage of the significant widening in corporate and non-Federal Government spreads.

In previous annual reports, we have discussed the holding of some common stock positions for the very long term. Last year we identified Johnson & Johnson as one name and said that Mr. Market may give us more opportunities in the future. As shown in the table below, at the end of 2008 we had taken advantage of the major decline in stock prices to purchase additional positions in outstanding companies with excellent long term track records which we contemplate holding for the long term.

On Page 10, Watsa describes the year that was in terms of Hamblin Watsa’s triumph in the market:

2008 was another very good year for Hamblin Watsa’s investment results, even excluding our CDS position which is not included in the results shown above. These results are due to Hamblin Watsa’s outstanding investment team, led by Roger Lace, Brian Bradstreet, Chandran Ratnaswami, Sam Mitchell, Paul Rivett, Frances Burke and Enza La Selva.

As I said earlier, the return that our investment team produced in 2008 was the best since we began in 1985 - 23 years ago! All of the investment risks that we worried about and have written to you about for at least the past five years simultaneously reared their ugly head as the 1 in 50 or 1 in 100 year storm in the financial markets landed in the fall of 2008. All the major stock markets worldwide were down about 50% and all corporate and non-Federal Government bond spreads widened to historically high levels. Risk was back with a vengeance and, as Grant’s Interest Rate Observer wrote back in 1996, “the return of one’s money, the humblest investment attribute in good times, is always prized in bad times”.

Long U.S. Treasury yields declined to 2.5% - a low not seen since 1954 - and 3-month T-Bills were yielding close to 0% for much of the fourth quarter of 2008. All parts of the U.S. economy and financial markets began to deleverage at the same time, led by financial institutions, hedge funds, businesses and individuals. Mutual fund redemptions began worldwide and the risk in common stock investing was exposed as stock markets declined viciously in the fourth quarter of 2008 and have continued to decline in 2009. Comparing levels at the end of 2008 and the end of 1998, most U.S. and worldwide stock market indices had not provided any return for the past 10 years. For example, the S&P 500 had a compound annual return of minus 3.0% (excluding dividend reinvestment) over the past 10 years. Of course, for the investor in late 2008, the returns in the future may be very different from the past.

Watsa writes of the various points of vindication, discussing where in past years he quoted Hyman Minsky, and Ben Graham admonishing investors to remain patient:

Last year, I quoted Hyman Minsky who said that history shows that “stability causes instability”. He said that prolonged periods of prosperity lead to leveraged financial structures that cause instability – and did we see that in spades in 2008!! With SIVs, CDOs, CDOs squared, among any other structures, leverage on leverage was exposed in 2008. Private equity firms that could do no wrong in 2005/2006 were down 90% from their IPO price in 2007. While Madoff may be the  biggest Ponzi scheme yet unearthed, what Mr. Minsky calls Ponzi financial structures, where interest and principal cannot be financed by internal operations, are being unmasked daily in the financial markets.

Structured investments based upon consumer debt that we warned you about for some time took a real beating in 2008, as 47% of the original AAA ratings on U.S. residential mortgage-backed and various other asset-backed securities issued between 2005 and 2007 were downgraded.

In fact, as of January 9, 2009, over 13% of those securities which had originally been rated as AAA had been downgraded to CCC+ or lower!

Last year, we quoted Ben Graham who said that only 1 in 100 of the investors who were invested in the stock market in 1925 survived the crash of 1929-32. Our experience has been the same.

On his outlook and investments:

We had to endure years of pain before harvesting the gains in 2007 and 2008.

We think this recession is going to be long and deep and the only comparable data points are the debt deflation that the U.S. experienced in the 1930s and Japan experienced from 1989 to the present time. While the U.S. government has initiated a massive stimulus program and is providing up to $2 trillion for its Financial Stability Program, the effect of these programs will be diminished by the enormous deleveraging going on by businesses and individuals: government in the U.S. only accounts for less than 20% of GNP while the private sector accounts for more than 80%. The situation will have to be monitored carefully over the next few years. Of course, many of these negatives are being discounted in the stock market and credit markets as stock prices are down more than 50% and credit spreads are at record levels. We have not had as many opportunities in both markets in our investing career and we are busy!

For the first time in more than a decade, we are very excited about the long term prospects of our common stock investments and believe that these investments have been purchased at prices well below their intrinsic values. This, of course, does not mean stock prices cannot go lower! Mark-to-market gains or losses on these investments will make our book value more volatile, but in the next five years, these investments should be a major reason for our success.

And if you happen to be in Toronto on April 15, 2009, that is when the company’s AGM will take place:

9:30 a.m. on Wednesday, April 15, 2009 in the John W.H. Bassett Theatre, Room 102, Metro Toronto Convention Centre, 255 Front Street West.

Our Presidents, the Fairfax officers and the Hamblin Watsa principals will all be there to answer any and all of your questions.

Download the letter here.

Tags: 23 Years, Berkshire Hathaway, Blockbuster, Canada, Common Stock, Cumulative Basis, December 31, Fourth Quarter, Hedges, Lean Years, Letter To Shareholders, Noah, Portfolio Investments, Stock Markets, Stock Price, Tax Exempt Bonds, Treasuries, Treasury Bond, U S Treasury, Warren Buffett, Year End
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