Advice as the storm blows on
Bob Rodriguez was expecting financial markets to come unglued this month. But after making that smart call, he’s in the same boat as the rest of us: What to do now?
Rodriguez, a veteran money manager who heads the Los Angeles-based First Pacific Advisors mutual fund group, has for the last year been railing against what he saw as off-the-charts risk levels in bond and stock markets.
By mid-December Rodriguez decided to impose an outright ban on stock and junk bond purchases at FPA’s five funds, telling his co-managers he feared severe market fallout in the new year from deepening financial-system woes.
He was prescient, all right. The equity and junk bond markets have crumbled in the last three weeks amid fresh worries about the health of major financial firms and the economy overall. The Dow industrial average is down 8.8% for the year and panicked investors have been rushing into U.S. Treasury securities as a haven.
Rodriguez has weathered plenty of market crises in his 37 years in the money management business. What ails Wall Street and the U.S. economy now, however, is something truly special, and not in a good way, he says.
“This is the worst credit crisis of my entire career and, I believe, the worst since the Depression,” Rodriguez says.
The good news is that the turmoil will inevitably lead to investment bargains, he says. Some already are visible, he adds: The “value” screens he applies to the market in hunting for stocks have turned up 253 names in recent days, up from just 35 in June.
Even so, he said he thinks it’s still too early to step up to the plate.
At its core, of course, what’s happening is the unwinding of the debt binge that powered the economy for the last few decades. That binge dramatically inflated housing values in this decade by creating loans that were roach motels for the borrowers: easy in, but no way out.
As everyone already knows, hundreds of billions of dollars of those loans were securitized and sold to investors. And debt was layered on debt: Many hedge funds, brokerages and others bought dicey debt with borrowed money, hoping to magnify their returns.
As home loans go bad at a frightening pace, the debt mountain has been generating avalanches in the financial system since July. Despite huge write-offs of mortgage-related securities at many banks and brokerages in the third quarter, Rodriguez figured there would be more to come this month -- and that the fallout would spread.
He was right. What has come to a head in recent weeks are concerns about another corner of mountain: the bond insurance companies that guaranteed massive amounts of mortgage securities against default, and now are on the hook as loans sour.
That, in turn, has exposed the risks in the multitrillion-dollar credit-default-swap market, where investors bet with each other on whether bonds and bank loans will be money-good or go bust. If too many of those bettors can’t pay up -- that’s called “counter-party risk” -- the domino effect in the financial system could be devastating.
“Counter-party risk is for real, and we don’t know where that leads,” Rodriguez says.
And so doomsday scenarios have been making the rounds again in recent days, evoking master investor Warren Buffett’s term for so-called derivative securities like credit default swaps: financial weapons of mass destruction.
Rodriguez, 59, is not in the doomsday camp. “We’ll recover,” he says of the financial system, but it will be a long process.
For stock investors, the question is how much more of a decline share prices will have to suffer between now and whenever the financial system stabilizes. That may depend on whether the economy slides into recession as a consequence of the credit woes, and how deep any downturn becomes.
Rodriguez, whose long-term investing records with his FPA Capital stock fund and FPA New Income bond fund have won praise from Morningstar Inc. over the years, says he’s staying cautious for the time being. He thinks investors would be smart to shepherd cash, waiting for better opportunities.
FPA Capital has 43% of its $1.8 billion in assets in cash. It’s in the red this year (down 7.7%) as its share holdings in sectors such as energy and retailing have suffered with the broad market. But Rodriguez’s value approach tends to lead him to companies that have the financial wherewithal to survive tough economic times, he says.
Like many value investors, he also prides himself on knowing his companies inside and out. That, he says, gives him the confidence to hold on even when the market is bludgeoning good stocks with the bad.
“If I’m going to get killed, I’d rather get killed in something I know,” he said.
As for the most popular securities of the moment -- U.S. Treasury notes and bonds -- Rodriguez says he has no interest in joining the herd of investors who have rushed into those issues as a safety play amid markets’ turmoil.
With the annualized yield on a five-year Treasury note at just 2.84%, there is no value in that return, Rodriguez said.
Dan Fuss, who manages $45 billion in bond funds for Loomis, Sayles & Co. in Boston and who, like Rodriguez, has shown a keen eye for value over the years, also warns investors away from hopping aboard the Treasury bandwagon now.
“The Treasury market has gotten completely irrational,” the 74-year-old Fuss said of current yields on those issues.
Fuss was smart enough to load up on Treasuries last year. Lately, he has been selling them as other investors have clamored for them, and has been using his profits to buy high-quality corporate bonds -- such as a 7%, 30-year issue that retailer Target Corp. recently sold.
Worries about the financial system are legitimate, Fuss said. Even so, he said, if the world isn’t ending, “this is going to mean a classic buying opportunity.”
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