We just passed the five-year anniversary of the collapse of
Bear Stearns and are heading into the five-year anniversary for a
bunch of other ugly 2008 moments.
That gets me feeling a little bit sentimental.
I remember 2008 like it was yesterday.
Early in the year I found watching the very beginning of the
crisis unfold to actually be a bit of a rewarding experience. I
was fortunate enough to be sitting on a big whack of shares in
both Odessey Re and Fairfax Financial (
) which were companies loaded with U.S. Treasuries and credit
default swaps that were rapidly increasing in value.
The worse the crisis appeared the more Fairfax's portfolio went
Both of those companies (Odessey since acquired by Fairfax) were
prepared to thrive in the financial crisis because
and his crew had seen the disaster looming years in advance.
You can see the share price spike upwards in 2008 in the chart
above as shareholders were rewarded for Watsa's foresight.
I enjoyed a good chunk of the ride up with Fairfax, but sold too
soon trying to take advantage of what I thought were "too good to
pass up on" bargains in the energy sector.
I should have just sat on my hands and stuck with Prem.
I'll get to the point.
Watsa is again preparing Fairfax for additional market turmoil
that he sees ahead. Given how prescient he was last time around I
think investors (myself included) should give what he is saying
Here is his latest from the 2012 Fairfax letter to shareholders:
Our common stock gains in 2012 were once again substantially
offset or eliminated by our hedging program.
While this is disappointing, we continue to be comfortable
maintaining our hedges because of all the uncertainties we see in
front of us. In 2007, a major U.S. bank CEO famously said "as
long as the music is playing you have to get up and dance". After
the Lehman bankruptcy in 2008, this same bank needed $45 billion
from the U.S. government to continue in business. Expensive
We prefer to wait for the music to stop and not depend on the
kindness of strangers to be in business.
We continue to fully hedge our common stock portfolios
because of the reasons first discussed in our 2010 and 2011
Annual Reports. Those reasons have not changed!
Total debt (private and government) as a percentage of GDP in
the U.S., Europe and the U.K. are at very high levels, thus
limiting the options available to governments. Deleveraging in
the private sector has only just begun. In spite of the
significant deficit spending in the U.S. and Europe, high levels
of unemployment prevail in both areas and economic growth
continues to be very tepid. In fact, Europe and the U.K. appear
to be heading for another recession.
The markets are ignoring this as they believe the Fed and the
European Central Bank will bail us out - again!
Forgotten is the fact that the present Chairman of the Fed,
in July 2008, yes July 2008, said that Fannie Mae and Freddie Mac
were "adequately capitalized" and "are in no danger of
In spite of QE1, QE2 and recently QE3, the economic
fundamentals remain weak while stock markets and bond markets are
back to near record levels, leading Gary Shilling, one of the
economists we know, to call this "the grand disconnect". This
"disconnect" or gap will be closed by either economic
fundamentals rising to meet the financial markets or the markets
coming down to meet the fundamentals.
We think that the latter is likely and that the Fed has
simply postponed the inevitable by its QE1, QE2 and QE3
In our 2010 and 2011 Annual Reports, we discussed the Chinese
bubble in real estate. This past Sunday (March 3, 2013), the CBS
show "60 Minutes" did a segment on the Chinese residential real
estate bubble. They showed vast empty cities with "new towers
with no residents, desolate condos and vacant subdivisions
uninhabited for miles and miles, and miles and miles of empty
apartments." They called it the biggest housing bubble in
history. We agree!
The ultimate collapse of this bubble will have major
consequences for the world economy.
Unlike in 2008/2009, when we quoted Grant's Interest Rate
Observer, "the return of one's money, the humblest investment
attribute in good times, is always prized in bad times", today
the "risk on" trade prevails everywhere, with investors reaching
for yield in corporate bonds, high yield bonds and even emerging
market debt. Junk bonds are yielding 6% (compared to 19% in early
2009) and emerging market debt outstanding has increased almost
ten times since 2003. For example, Bolivia's recent $500 million
10 year bond, issued at 47?8%, was 9 times oversubscribed even
though Bolivia had not issued a bond in 90 years!! Poland did
even better, issuing a 10 year bond at 33?4%. Russell Napier at
CLSA, in a recent issue of his "Solid Ground", noted that U.S.
dollar emerging market issuance in open ended mutual fund
structures is a disaster waiting to happen as these capital flows
can go into reverse! This is particularly negative as external
debt in many emerging market countries has increased to dangerous
In the same report, Napier also provides a fascinating
historical survey of the pitfalls of reaching for yield -
particularly when government risk-free rates are very low.
Indeed, over the last few hundred years, trying to achieve a 5% -
6% long term yield when U.S. and U.K. government yields were half
that led to the destruction of much capital.
We have had massive fiscal and monetary stimulus since 2008
with interest rates effectively zero - and economic recovery is
still limping along. We continue to believe the 2008/2009 great
contraction was not like any other recession the U.S. has
experienced in the past 50 years. We think it has many
similarities to the U.S. in the 1930s and Japan since 1990 - and
Japan is still fighting deflation 20 years later.
From the distant past comes the warning of our mentor, Ben
Graham, whom I have quoted before: "Only 1 in 100 survived the
1929 - 32 debacle if one was not bearish in 1925". We continue to
be early - and bearish!
So far, on paper, this conservative stance has cost Fairfax and
its shareholders quite a bit of money. Fairfax is sitting on $1.8
billion of unrealized losses (as of Dec. 31, 2012) in its equity
hedge and CPI derivative portfolios.
Of course, that was what the situation looked like last time in
2006 when Watsa's credit default swaps looked like a bad idea.
. Always early, and usually right.
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