Ramblings of a Portfolio Manager

So Many Worries, So Little Concern.

Riddle: What do volcanoes, Government bureaucrats, oil rigs, nuclear terrorist attacks, Chinese inflation, Greek tragedies and dead comedians all have in common? Hint: they’re all related to the US equity markets. Give up? Answer: despite massive negative headlines regarding the first six items the US equity markets have taken very little notice in the way of profit taking, continuing their slow upward trend and earning a nickname from the seventh: the “Rodney Dangerfield” rally. After a brief sell-off following the news of the SEC fraud case against Goldman Sachs for some probably legal but seemingly unethical behavior just prior to the Financial Meltdown of 2008, which took more in market cap off the US equity markets than the entire value of Goldman itself, the Markets resumed their climb and the S&P 500 and Dow gained 2.1% and 2.5% respectively for the week. The so called “risk trade” was back in fashion as evidenced by the small-cap Russell 2000’s corresponding strong 3.8% gain. Even a 6% slide in the Shanghai Composite on further Chinese Government tightening, it biggest since January, couldn’t pour cold water on the US markets for long. After spiking to near 20 on the Goldman fraud case news, the VIX fell back and remained below 17 for the week.

So with a stock market rally amidst all the negative headlines, a rally that is almost universally proclaimed as “having no respect,” it seems we are climbing the so called “Wall of Worry,” that quaint old Wall Street term for a rising stock market in the face of general pessimism about the economy and Market itself. Well, maybe. According to the Investment Company Institute last month, equity mutual funds consumed their excess cash at the fastest rate in 18 years, leaving them with the smallest reserves since 2007. Cash as a percentage of holdings dropped to 3.6% of assets in March, down from 5.7% in January 2009, the quickest decline since 1991. According to the ICI the last time equity managers held such a small proportion was in September of 2007, a month before the S&P 500 began its 57% drop. This would signal that investors are already fully invested, a sign that optimism, rather than a wall of worry, prevails on Wall Street. However, this ICI data point just measures cash on hand within equity mutual funds, whose mandate is to spend their available cash in the stock market anyhow. Looking at other, non ear-marked, sources of cash, more recent data shows that investors have still have nearly $3 trillion in money-market funds as of the end of last week and although this number is down 25% from a year ago, the year ago number represented the peak in money fund assets during the Financial Crisis. The current money market balance is roughly the same as it was at the beginning of 2008, after the equity markets had already experienced a full quarter of fund redemptions from the markets’ peak in October 2007. In addition to the money market data, ICI shows that flows into equity funds through the end of last week slowed significantly while flows into bond funds continued strong and outpaced that into equity funds at almost a 3:1 rate, in line with its average this year. All this signals that if the markets are rallying due to complacency, euphoria and the so-called “dumb money” rushing in, it sure isn’t supported by the data. The Wall of Worry, then, just might be intact and growing.

A word on Goldman Sachs. We aren’t securities attorneys (thank God!) and so will not pass judgment on the culpability of Goldman vis-à-vis its purported actions. We are, however, market watchers with a background in the analysis of financial services firms. Our only comment on this whole controversy is a reminder that the tangible assets of financial services firms go up and down the elevators each day—that would be the employees—and that the intangible assets are written on air—that would be their reputations. Merrill Lynch, Bear Stearns and Lehman Brothers failed due to leverage and the failure to manage the risk thereof. That isn’t the case here so we look further back in history for guidance on the possible fate of Goldman. Unfortunately, we are old enough to recall Drexel Burnham Lambert, E.F. Hutton and Kidder, Peabody as potential examples. These brokerage firms failed not due to excess leverage or bad financial management, but due to the rapid loss of market reputation and, thus, market clout. In all cases it was the actions of certain employees who set the cataclysmic chain reaction in motion. Whether or not Management was involved was irrelevant as the questionable behavior was seen as symptomatic of the corporate culture of each firm. However it began, the reputational impact was the beginning of the end. We don’t suggest that this fate awaits Goldman but, perhaps more likely, it does await its current Management.

Despite Wall Street being labeled as monopolists by the current Administration, its bread and butter business is, in fact, largely a commodity. This has two implications of which to be mindful: First, if you operate in a commodity business, your only edge is your reputation and that can be fleeting. Goldman Management--and investors in its stock--beware. Secondly, for all other investors, know that in a commodity market, no one firm is indispensable and many participants can come and go without causing harm to the health of the overall market. Despite what they would have you believe, Goldman doesn’t have a monopoly on brains, creativity, innovation or market influence. When Drexel folded the junk bond market remained healthy and vibrant. BBB or lower companies could still access the capital markets and the existing “junk” in investor hands could still be traded. Other firms quickly sprung up to fill the void, many with ex-Drexel employees at the helm. Yes, a Goldman failure (and we aren’t suggesting this) would send ripples through the financial markets but just as ripples in a pond, these will fade with time reestablishing the earlier relative calm. Should Goldman fold or exit certain markets the capital markets will remain liquid, strong and healthy and other firms will emerge to fill whatever void might be created. And if all Wall Street firms are restricted in how they do business in certain products or markets, remember the Wall Street is all about innovation…there is no way a bunch of bureaucrats and regulators can keep up with the new products that will be created. So our word to investors is that while Goldman Sachs stock itself is probably not worth the risk of committing more money at this time, the overall market, should it sell off on any negative news regarding Goldman, certainly is. Just maybe avoid investing in Hamptons’ and Upper East Side pre-War real estate for the time being…