Market dislocation?

Interesting email exchange between me and friend below. Question asked of me in italics and my response below that. Just my thoughts.

How does the current market dislocation affect our market, particularly in the medium to long term?

- For example, if it requires reducing leverage by 1-2x, for deals to clear the market, does this mean valuations on the indexes (ex - Russell 2000) should be taken in accordingly?
- What might be the impact on an existing portfolio?

A few thoughts. First of all I wouldn't really term what is going on as a market dislocation. It is to some degree but I look at the environment we have been living in the last two years as a truer market dislocation. Spreads in the credit market where non-existent. If you believed what Jeremy Grantham was saying (which I did and do) not only was the investors getting paid zero for risk in the credit market but they were actually paying to take the risk!! Liquidity was sloshing around like beer at midnight at a German wedding and things were getting done that were just insane. What we just went through in the credit markets and the housing market was a bubble just like the South Seas Bubble, just like the technology bubble and what we can expect is bubble aftershocks. In my opinion that is where the market dislocation occurred and we are getting back to normal. Now obviously things are not trading like they should as liquidity has dried up and that is somewhat of a dislocation as it is almost impossible to trade a mortgage back security but long term spreads from here I think will stay much higher than what they were 6 months ago. One of the primary reasons is who bought much of this stuff. Americans investors have gotten hurt in all of this yes but who have gotten really burned are people outside the United States. A German bank had to be bailed out by the German government. Two to three UK and Australia hedge funds are on the ropes or have to shut their doors. Do you think our big creditors (i.e. other countries in the world) will all of a sudden jump in and say eww we want to lend you money now? Not at previous rates and my guess is to some degree not at all for awhile. As a result a mortgage is going to have be funded by U.S. investors instead of foreign investors. We are entering back into what should be considered normal looking at a historical perspective but of course quite a few of investors do not have a historical perspective. My guess is we will over correct just like we did going into 2003 with the equity market.

As a result I think you will see a rise in corporate defaults to normalize levels. That has not started yet but maybe 12 months from now as companies that have continually refinanced (i.e. movie gallery) when they should have had no access to capital markets where able to extend their life by refinancing. That life line is now gone and we should see a more normalized level of default rates (for those lenders who are lucky enough to have covenants rather than see value disappear)

As far as valuations for the Russell 2000 etc a couple of thoughts on that. One is that large cap U.S. stocks I think are one of the more undervalued asset classes in the world today. I think they will easily outperform debt over the next 24 months. With that said there are some major issues. Profit margins as you probably know are at all times high. Are these normalized earnings? I would be doubtful. Of course these profit margins are that way because of the overall world deflation in labor as outsourcing has taken center stage. This has started to reverse and we are starting to enter into an inflationary world unlike three years ago. This may be several years out from reversing however. I am wary of those who think we are going to see dramatic downshift in profit margins in the next year or two. Alot of the drop we have seen in markets is the buyout discount disappearing. The takeout premium has become zero. Of course that does not really change intrinsic valuation. The leverage thing has nothing to do with valuation. It just amplifies returns (both positive and negative) for the equity holders. Dropping leverage by 1X or 2X changes true intrinsic valuation by a grand total of ZERO. (May be some slight tax differences that may change it a little) What changes intrinsic valuation is some of the things I described above. Company X wants to build a plant to grow product Y that is a positive DCF project and now they can't do it because the markets are overly skittish (I think this will correct itself before terribly long)

Depending on what the fed does the market may have bottomed. I doubt it. I think the market will probably go down from here and at least complete a true 10% correction though we may have a couple of more 200 point rallies between then and there but in general unless we have a complete unwinding (which their is some chance of that happening) the markets are not really dramatically overvalued.

So anyway back to your first question. How does the current market dislocation affect our market, particularly in the medium to long term? My answer we get back to normal (after probably swinging to abnormal on the downside) and those bank deals or mortgage deals or bond deals that were priced in the last 12 to 24 months will continue to trade a steep discount to more appropriately priced deals that get done from this point forward.

Regards,