Dive When You See Only Rocks

The young man stands perfectly still contemplating the near future. In less than three seconds, if all goes well, he will be floating in the warm water that stretches to the horizon in three directions. All that separates him from the comfortable swim awaiting him is 136 feet of pure Acapulco air. Despite the height, the jagged rock cliffs flanking either side of his narrow aerial pathway, and the unpromising physics of flesh and bone piercing the churning waters below, he feels oddly calm. He has done this many times and knows that those who came before him, those who taught him to perform this rare feat, have been doing this for over 50 years. In a flash, he jumps and during his few seconds of human flight his emotions fluctuate wildly between mortal fear and otherworldly excitement. Then, in an intense adrenaline rush, he hits the water at nearly 50 mph. Although the 9 ½ feet of water seems too small to be an adequate landing pad, it embraces him, safely and perfectly. Relief now overwhelms him and he briefly basks in the satisfaction of yet again having performed well the task he has chosen as his vocation.

We recently heard stories of the cliff divers of La Quebrada and had to marvel at their courage and skill. As with many things, the devil is in the details. We learned that the most difficult part of this extreme sport is timing the tide. The depth of the water in the narrow inlet, into which the divers dive, at some times during the day, varies greatly with the tide. According to the accounts we heard, to assure the maximum depth of water at impact, the diver must jump off when he sees only rocks below. To jump when the water appears to be at it deepest and safest, will lead to an unfortunate outcome.

As we reflected on the experience of the cliff divers, we began thinking about the perceived perils of investing in the equity market. While not a life or death exercise, equity investing to some must feel now like an endeavor with only unfortunate outcomes. Regardless of the causes, a great deal of investor wealth has been damaged over the last four months, and concern about the future remains high. Although we have seen some improvement in many of the quantitative measures the capital markets use to measure fear and risk (VIX, LIBOR, Corporate bond spreads, interest rates, etc.), fear on Main Street has yet to abate. It’s as if investors can only see rocks and do not expect the water to ever refill the inlet.

There is a palpable feeling that somehow, things will never get better; that somehow everything is broken beyond repair and that all avenues to grow assets have been blocked off permanently. This feeling is hard to shake when nothing but bad news assails the senses daily on TV and in the newspapers. Corporate losses, layoffs, reduced expectations about future earnings, cancelled orders, bankruptcies, foreclosures and scandals have become commonplace, and there seems to be no end in sight.

Yet we, like the cliff divers, have been taught by our elders to know when to dive and to know that there will always be water there when we land. History has shown us that EVERY recession since 1929 has ended (the average length after the 1930s has been 10 months) and that the stock market ALWAYS begins to recover long before the recession ends. There are two reasons why we think this recession may not last as long as the consensus expects: 1) High Cash Levels and 2) the Government’s Response.

Many have concluded that cash is the only “safe” investment out there. Money market assets have ballooned to over $9 trillion, the highest level on record (and more than the entire S&P 500 market capitalization). Granted, cash can’t lose its value, but it doesn’t grow value either. We would argue that cash is the riskiest investment possible right now for investors looking to grow assets over time. Historically, high cash levels ALWAYS precede big market rallies. We wonder why this time could be any different.

One could debate for hours whether the government’s response is the “right” one, but at least it’s doing something. It has so far avoided the huge missteps that exacerbated the Great Depression (do nothing for a long time, then pass protectionist measures and raise taxes). Easy monetary policy is a huge boon. Supporting the commercial paper market has been a critical and positive move. Even the stimulus package might help.

All in all, we see only rocks right now and think this is a great time to dive into the equity market. Some stocks such as Leucadia National (LUK), Cemex (CX), Whirlpool (WHR), Western Union (WU) and Veolia Environnement (VE) appear to be discounting worst-case scenarios and could offer better-than-market returns over the next few years.