Byron Wien

Byron Wien’s March 2009 Commentary Karl Marx Must Be Smiling While Karl Marx was doing his research and writing in the British Museum, he was inspired by his vision of the collapse of capitalism. He did not believe any nation would embrace communism because it was a fairer and more effective form of government. He thought communism would succeed as an alternative to the boom and bust cycles of the free market system. Even in Russia, after the revolution in 1917, this notion prevailed. In 1930, because of a lack of foreign exchange reserves, the Russian government arranged a complicated secret sale of 20 of the most valuable paintings from The Hermitage, including a Rembrandt, a Raphael, a Titian and a Botticelli. They were bought by Andrew Mellon, then Secretary of Treasury, on the condition that Mellon’s possession of the paintings would not be revealed. The Russians were convinced that capitalism was in the process of collapse during the years after the 1929 crash and that they would be able to buy the paintings back at bargain prices within a decade. In spite of the financial and economic calamity developing around him, Mellon spent most of his time concentrating on the details of the art transaction. The daily matters of the Treasury were left to Ogden Mills, the Deputy Secretary. Mellon’s view of what was happening was harsh. According to Liaquat Ahamed, whose exceptional new book Lords of Finance chronicles the economic events and people of the period after World War I, he believed the economy was “fundamentally sound” and would “rebound of its own accord.” To deal with the problems resulting from the crash, he suggested that the best policy was “to liquidate labor, liquidate stocks, liquidate the farmers, liquidate real estate and purge the rottenness out of the system. People will work harder, live a more moral life, values will be adjusted and enterprising people will pick up the wrecks from less competent people.” Mellon’s approach is a sharp contrast to the interventionist policies of the Obama administration. The debate now is whether the President’s ambitious program will enable the banking system to function effectively without nationalization, whether widespread home foreclosures can be avoided and whether jobs will be created. One thing we know for certain is that Treasury Secretary Tim Geithner won’t be spending much time pursuing his hobbies. In addition to his already full plate of financial and economic problems, he is now saddled with helping to get the American automobile industry on a viable course. The widespread reaction to the Administration’s ambitious program to stabilize the economy and get it back on a growth path seems almost universally negative. The $787 billion Economic Recovery and Investment program is viewed as too heavy on tax cuts (which will probably be used to pay down debt) and too light on job creation. In any case, the program is being criticized for being too back-end loaded with most of the stimulus coming late this year or in 2010. The $225 billion program to stabilize housing is viewed as insufficient in relation to the scope of the problem and unfair to those responsible citizens who bought a house they could afford and kept up the mortgage payments throughout the economic turmoil. The Obama administration seems to have a clear policy for the financial service firms: save the innocent. Depositors at banks and holders of insurance policies should not be disadvantaged. Stock and bond holders who had capital at risk should be made to sacrifice most if not all of their investment in troubled institutions. We still don’t know the details of the program for the banks, but I find it ironic that many free marketers believe that the troubled banks should be nationalized, common and preferred shareholders should have their equity written down to zero, and the bond holders should have their holdings wiped out as well, or converted to some form of equity. In their model, the government would provide capital Pequot Capital Management, Inc. ▪ 500 Nyala Farm Road, Westport, CT 06880 ▪ Tel 203.429.2200 ▪ Fax 203.429.2400

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for the banks meeting the “stress test” and basically have a say in policy and control operations going forward. The thought of the government running the major lending institutions, making them susceptible to political influence, seems like a nightmare to me. I don’t know whether Karl Marx is watching all this from heaven or hell, but I do know he must be smiling. I wonder if we are too impatient with our new President. After less than two months in office the stock market is still declining, house prices continue to drop, the futures of the banking and automobile industries remain uncertain, corporate profits are shrinking, industrial production is falling and unemployment is rising. Did we really think he would come out with a flawless plan to reverse these conditions within the first 60 days? The programs announced so far are not bereft of positive aspects. You can criticize the stimulus package for having been written by various congressional committees who put their pet projects in the bill but the legislation contains programs for alternative energy, the environment, education and healthcare which were all promised by the President during the campaign. What’s more, support for the infrastructure projects at the state and local level creates jobs or keeps public employees from being laid off and attends to deferred maintenance projects that may have been on the books for years. More than $1 trillion dollars has already been committed and it may be several times that before we are done in a $15 trillion economy. That’s probably going to be a boost to the gross domestic product (GDP) of five to seven percent starting this year and continuing into next in an economy that is shrinking at about five percent. Even the pessimists think GDP will turn positive late this year or early in 2010. Nobody knows when the stock market will bottom, housing will stabilize, the banks will feel solid enough financially to start lending again, unemployment will turn down and fear among consumers and business people will dissipate. To assume that there are not a number of constructive aspects to the programs announced (and passed) to date is too harsh a judgment in my opinion. It took decades to create the problems we are facing and it will take years to solve them. The long-term implications of the debt we are taking on to accomplish our goals are another matter, but the economy was in free fall and a series of dramatic steps had to be taken. So I remain one of the few optimists who believe the market will begin to anticipate a recovery in the economy sometime in the second half of this year. I am prepared for the fundamental backdrop for equities to get worse before it gets better. I expect earnings will be disappointing and company guidance will be revised downward and more layoffs and bankruptcies will take place. However, once the positive effects of this enormous stimulus program begin to be seen, I believe the stock market will have already anticipated the good news. Even if the fundamentals only show improvement in 2010 we could see a better stock market later this year. I had hoped that the climax lows of October and November of 2008 would hold. In the week ending October 10, there were 2,801 stocks that made new lows and I referred to that sell-off as a “Black Swan” event. Since the inauguration, the mood of the market has worsened. Withdrawals of cabinet nominees, the lack of a detailed program for the banks and a stimulus program written more by Congress than the Administration have diminished investor confidence. All of this is surprising from an Administration that ran an almost error-free election campaign. The financial press reminds us daily of The Great Depression in the 1930s and Japan’s 12-year deflationary recession at the end of the last millennium. In The Great Depression we had four years of negative GDP, industrial production declined 54% and unemployment reached 25%. I don’t think we’re headed for anything like that. We’re providing substantial stimulus to the economy and expanding money supply to provide liquidity. Money supply was contracting in the 1930s. The response from Washington should provide a safety net to the economic system and if what has been announced does not prove to be enough, I am confident more will be done.

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As the economic news around the world continues to deteriorate, confidence has eroded further. A bank in Ukraine is failing, manufactured exports out of Germany are falling and there is dissention in the European Union about what remedial steps should be taken to reverse the negative trends. In the United States, the government had to invest more in American International Group to keep it from failing and the banking industry outlook continues to be uncertain. The stock market lows of last fall have been definitively broken without a new climax low having been established. The market is oversold but buyers resist because the outlook is so clouded and the solutions may not work. The prospect of incurring trillion dollar budget deficits each year for several years is daunting. What impact that is likely to have on the credit markets and corporate profitability is unknown, but is likely to be unfavorable. Taxes will increase and interest rates are likely to rise as well. The willingness of foreign investors to buy our debt in increasingly large quantities is problematic. Strategists and analysts continue to cut their earnings estimates. The Standard & Poor’s 500, which had operating earnings of $83 in 2007 (and $88 the year before), is now only expected to earn $45 or less. Investors debate whether whatever earnings level is achieved should sell at a peak, trough or average multiple. This results in a possible range for the index of 600 to 900, meaning the market might trade later this year flat with its level at the end of 2008 or down one-third. Having been down 37% last year, the S&P 500 is already down more than 20% in 2009. Unfortunately, we are in a period where the bad news keeps coming and the good news has not started. This could continue for some months. The free fall of stock prices will end when sellers become exhausted and realize that stocks have reached a point where they should be held or bought in spite of the uncertainties in the outlook. Part of this depends on what happens in the economy in 2010 and beyond. By now, everyone recognizes we are not in a normal cycle and stocks will probably not snap back as they did in the bear markets of the past 35 years. Economic growth is likely to be slower as excessive leverage is unwound, earnings recovery may be less dramatic and the government may be a more pervasive force in business and finance. I don’t think capitalism is in the process of failing but our economy was overextended and is now paying the price. Unlike Rush Limbaugh, I am not hoping the Obama program will fail. I am cheering for it to succeed and I believe it can without impairing the individual liberties that make America exceptional. If I am right, that should wipe the smile off Karl Marx’s face and we should have a better market in the second half.

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