Lumbard & Kellner, LLC

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Lumbard Investment Counseling is a traditional investment advisory firm. located in Hollis, NH.

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A Christmas Letter
To Our Clients


December 2, 2008

Dear Friends,

Recently a client asked how his account could be down less than 10% for the year, despite having half of his assets invested in stocks.  The answer is in several parts:

1) We expected a recession, and invested only in stocks and bonds that should hold up well in a shrinking economy.

2) Each of our accounts has had a large investment in U.S. Treasury bonds, which have paid interest at a 5% rate while appreciating roughly 15%.  Bonds rise in price as interest rates fall, and long-term bonds rise the most.

3) We held shares of a new fund that bets against oil prices, and oil prices fell.  Last year we suffered while holding shares of a fund that bet against oil stocks, and while those stocks have declined in recent weeks the price of oil itself has declined a lot more.

4) We used similar funds to place a small bet against technology stocks, and even bet against financial stocks for a very short period of time when they were declining.

We also made a bit of money by purchasing a couple of utility stocks at the October low, but the gains have been offset by purchases that didn’t go up.  It’s been a tough market! Generally we feel that investors have treated our numerous electric-utility and drug stocks unfairly, because they are supposed to hold up well in a recession.  They were caught in the downdraft along with everything else.

What’s the biggest problem the economy faces right now?  We don’t need any more houses or cars, and we’re pretty well set for home furnishings and appliances, clothing, computers, and just about anything else you can think of.  That sounds like great news—we’re all rich!!—but it doesn’t offer much hope for employment.  Our best guess is that it will be nearly two years before Americans feel a need to buy big-ticket items again, and in the meantime the herd instinct that created all those crazy bubbles will keep us sitting on our hands in unison. 

The Fed is printing money as fast as it can, and it won’t be long before the credit crunch begins to ease noticeably.  The economy will still have lots of issues to sort out, as this is not an ordinary recession but rather the long-cycle downturn that persuades millions of people to pay off all their debts and never borrow again.

Recessions are natural events in a free market.  They clean out debt and punish those who take foolish risks.  In this last cycle the famous brokerage firms of Wall Street borrowed $30 for every dollar of capital that had been invested by their shareholders! They put that money into mortgages and other securities, dimly aware that if the value of the mortgages declined just 3.33% that dollar of shareholder capital would be wiped out.

Recessions punish that sort of stupidity, and force businessmen to set aside greed, hope, and other emotions when making important decisions.  The bad news is that we nevertheless accumulate debt as decades pass, until—every three generations or so—we experience a bigger event that really whups people upside the head.

This looks like the big one. These events are always painful, and if the government makes dumb mistakes (tax increases, government programs, entitlements, earmarks, bailouts of the wrong kind) they can go on for years.  Japan had a 12-year recession after the bursting of its stock-market and real-estate bubbles in 1989;  an event that so terrified the Congress in 2001 that they wouldn’t even let the recession of that year unfold in normal fashion.  They undertook “stimulus programs” and spent like drunken sailors, continuing the party long after the economy had recovered.

The Fed also lowered interest rates, and the result was a giant bubble in the real-estate market that was fed further by Congressional efforts to extend home ownership to the poor.  Millions of Americans bought houses for the first time, putting very little money down and running up debts that they couldn’t possibly repay. Investors bought mortgages with a crazed enthusiasm (how can you have a bubble in mortgages?), stuffing them into portfolios without a second thought—as they told each other, over and over again, that real estate prices never decline and that mortgage-default rates can’t rise because people want to stay in their homes.

What do we need to bring an end to this recession? Time.  Eventually consumers will need to buy new cars and carpets, and at some point we’ll even need to build more homes. The biggest dangers we now face are the herd behavior of consumers (“we have nothing to fear but fear itself”), and the likelihood that the Congress will stick its dirty fingers in the pie and do some long-term damage. Government programs can stimulate parts of the economy in the short term, but they always suck resources from other parts of the economy.  And they create disincentives to hiring, expansion, and entrepreneurial activity that few legislators can grasp.

At the moment we don’t see any reason to place bets on economic recovery, because there are so many wonderful opportunities to buy the bonds and stocks of corporations that should continue to earn money in a recession. Mutual funds, hedge funds, banks and insurance companies, starved for cash by the credit crunch, are selling bonds at wonderful prices.  We’re getting 10% yields on bonds issued by giant telephone companies and railroads, and even bigger yields on bonds issued by banks that the government would never allow to fail.

Of course, when you can get 10% on a company’s bonds, you should be able to get an even higher return on its stock. The stocks of electric utilities—with growing dividends—now routinely yield 7% or 8%, and we expect them to appreciate no matter what the economy does.

Today the stock market rallied, after dropping to the lowest point of 2002.  When you say it that way it doesn’t sound so bad—we’ve merely rolled the clock back by 6 years—and a look at the long-term chart shows that the recent 50% decline in the market is a mere blip in the long-term uptrend.  Thirty years ago the Dow was at 800, and thirty years before that it stood at 177!  During the next three decades it will multiply fourfold, or tenfold, or somewhere in between.

We think that there’s a good chance that the Dow will drop to 7000 during the next year, but we know for a fact that today’s lower prices mean bigger investor returns in the next decade. We didn’t feel at all confident that we’d be able to get double-digit returns for our clients when the Dow was at 13,000, but at Dow 8,000 the future looks bright indeed. 2009 is going to be a difficult year, but you have to keep your eye on the long term and remember that we will return to the 13,000 level in just a few years.  If we start from 8500 it will be a 53% gain (over and above the giant dividends we’re collecting), and if we start from 7,000 the gain will be 86%.


                                                   All the best,

                                                   John Lumbard, CFA

Please see the January, 2008 issue of Insight.

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