If the public has an interest in promoting home ownership, it should not be by slapping cheap insurance on wildly heterogeneous credit risks, with no residual risk to the mortgage originator. It certainly should not be through Fannie Mae and Freddie Mac, both of which have been disastrously managed. This is not a surprise - it has been clear for nearly a decade that these institutions have operated with far too much risk and far too generous assumptions about the impossibility of default and risk mismatches. Even in 2002, the GSEs were producing large duration mismatches that threatened their solvency to a much greater extent that investors understood, which is one of the reasons I noted in January of that year " I don't even understand why Fannie Mae trades at all." Except for a note or two suggesting that my view was preposterous, nobody cared. But one can only play balance sheet roulette for so long. Fannie and Freddie became penny stocks about a week ago as it was announced that they would be delisted.
It may grease the skids of capitalism for investors to treat all GSE securities as homogeneous, and all credit risk as being perfectly described by a letter of the alphabet. The wheels of Wall Street are constantly churning to create credit default swaps and payment guarantees to make investors believe that no thought is required of them other than to hand over their money. But this belief in uniform quality is a delusion. The institutions that provided these guarantees were at far more risk than investors understood, which is why AIG, Fannie Mae and Freddie Mac were the first to go down, and why the U.S. public is paying hundreds of billions to make sure that bondholders get a good deal despite the failure of the underlying collateral.
As Bill Hester notes in his latest research piece The Great Divergence (additional link below), it is also a mistake to view international debt and equity to be of uniform quality. Distinctions and selectivity among investments will most probably be increasingly important as we move through the coming years.
Market Climate
As of last week, the Market Climate for stocks remained characterized by unfavorable valuations and unfavorable market action - a combination that has been unfortunately frequent over the past decade, but has historically occurred only about 25% of the time. A natural consequence of the frequency of this particular Climate over the past decade is that the S&P 500 has delivered a negative total return over this period. This outcome underscores the fact that market outcomes on average do vary with valuations and market action. But it also reflects an economy that has constantly misallocated resources because we have embraced quick fixes, bailouts, speculation, cheap money, and quarterly operating earnings, rather than careful risk assessment and a focus on long-term solvency and properly discounted cash flows. Frankly, if one good thing comes out of the recent (and likely continuing) trouble, it will be revulsion toward "playing" the market as if it is some sort of carnival.
The Strategic Growth Fund is fully hedged here. In this position, the primary source of day-to-day fluctuations in Fund value is the difference between the stocks owned by the Fund and the indices we use to hedge.
In bonds, the Market Climate last week was characterized by moderately unfavorable yield levels and favorable yield pressures. Credit spreads continue to widen, and we've observed a flattening of the yield curve due to a flight-to-safety in default free instruments. This may seem like an odd outcome, given that the growing issuance of Treasury and Fed liabilities is gradually setting us up for a difficult inflationary period beginning in the second half of this decade, but it is a strong regularity that "default-free" beats "inflation prone" during periods of crisis. For that same reason, we have to be careful about concluding that the growth of government liabilities will quickly translate into continued appreciation in precious metals and other commodities. Again, the historical regularity is for commodities to decline, though with a lag, once credit difficulties emerge. My weekly comments on this might be less redundant on this front if there were more subtlety to the issue, but it is subtle enough to recognize that the long-term inflationary implications of current monetary and fiscal policies will not necessarily translate into negative short-term outcomes for the Treasury market, nor persistently positive short-term outcomes for commodities.
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