The rapid succession of events in the financial services sector over the course of the last few days is one of the most significant in memory. For long-term investors, now is not the time to panic, given the steep declines in many stocks already. In the near term however, we expect more volatility in the capital markets. The potential for further failures in the financial sector still exists as weaker companies remain vulnerable.
Citing deteriorating market conditions and tighter credit for “some businesses and households”, today the Federal Reserve cut the Federal Funds interest rate by 0.75% in an emergency move a week before members of the Fed would normally take such a step. It is the largest single reduction in the rate since 1990 and the first ‘emergency’ rate reduction since a week after the 9/11 attacks. In and of itself this action by the Fed is newsworthy.
The write-offs Citigroup is taking are a result of the bank’s direct and indirect exposure to sub-prime mortgages. As default rates rise on these mortgages, it ultimately impacts the derivative securities they comprise as packages of mortgages held widely by hedge funds, etc. As we all know by now, Citigroup was not alone in having exposure to these investment vehicles, as many banks and brokerages are now suffering from the fallout. The uncertainties surrounding the potential size of the write-offs, the quality of Citigroup’s balance sheet, and the management changes are having a significant impact on Citi’s stock price. Since Citigroup is widely held in our accounts, we are monitoring the developments closely and are obviously disappointed in the recent results.
It may strain credibility to suggest that 300 point declines are nothing to worry about. But after close observation and thoughtful consideration over the past fortnight, we are compelled to offer a rational response to the media’s hysterical treatment of recent events.
Since 2002 we have been in a bull market for riskier assets, and in the market for risk, generally. This rally in the appetite for risk was manifested by record narrow yield spreads on junk bonds, exuberant multiples for small stocks, very low capitalization rates (yields) on commercial real estate and, among other things, a very strong performance by emerging market equity and debt.
Pfizer suffered a significant setback recently when the company terminated the development of a promising new cholesterol treatment, Torceptrapib/Atorvastatin (T/A). It was hoped that T/A, the first in a new class of cardiovascular treatments, would eventually replace Pfizer’s most important drug, Lipitor, which loses its full patent protection in 2011. Lipitor is the leading cholesterol drug in the world with annual sales of over $12 billion, roughly one quarter of Pfizer=s annual revenues.
Since early August, the price of crude oil has declined by more than 12%. Although $64 oil and $2.60 gasoline would have been viewed as disastrous for the economy just a year ago, the decline has provided instant relief for the market in general, and consumer-related stocks in particular.
Among the more difficult elements of our research process is to acknowledge when our reasons for owning a security need to change. Such is the case with Sara Lee (SLE), a somewhat special situation for us, which we recognized was a pure cash flow story we found compelling even without a good growth outlook. Several clients questioned us about this idea, and we want to be clear about our recent decision to sell the stock in the face of SLE’s discouraging guidance concerning the outlook for profit margins. Below is the analyst’s most recent commentary on SLE.
Despite continued strong economic growth, most investors saw very modest returns for the first half of 2006. Although the major stock indices showed meaningful gains earlier in the year, the market corrected in May and June in response to inflation concerns and higher interest rates. As of June 30th, the Dow Jones Industrial Average and the S&P 500 Index produced total returns of 5.22% and 2.71%, respectively.
