The Past as a Portal to the Future - Part 2

In my continuing quest for "Truth" where the economy and markets are concerned, I have been reading up on some of the more pessemistic points of view. I have never been a very good pessemist, even though I can talk a good game. By definition, the pessemistic perspective is extreme, and therefore less likely than some middle-of-the-bell-curve scenario. I am inherently a pragmatist and live in the middle of that bell curve. But even if I have a hard time following with actions the completely negative point of view, knowing it helps harden me against the possibility of it coming true. So, it is worth knowing and understanding.

I have read books by super-Bears, Robert Prechter and articles by David Tice. I am even willing to listen to or read Marc Faber, Bill Fleckenstein, Doug Kass and Jeremy Grantham, all of whom have been right to this point in time about the depth and severity of the financial crisis. But most of these guys have been calling for the 2008 market since the mid-1990s or earlier. Had I gone to cash when they first recommended it back then, I would still be down today from where I am. I find timing the market to be very difficult because of my optimism about the future. The only time I can bring myself to sell is when stocks or funds are obviously overvalued as the Techs were in 2000 at 50 or 100 PEs, or when gold was at $1000 earlier this year.

But after weighting my portfolio to large cap, low P/E, high dividend payers, I have mostly held on through this firestorm knowing that even in the deepest depressions (1930s) a consistent program of reinvesting to average down cost will eventually get one back to even. But being out of the market and getting left behind leaves almost no chance of ever catching up. As they say, "there is no bell ringing at the bottom". If the market were to rebound 25% to 11,000 in February, how many people would then invest. How many more would consider that to be a "dead cat bounce" and continue staying on the side line, perhaps as the market went higher? This is the danger of getting in and out of the market. (for readers in retirement without the requisite 10-15 year time frame to absorb the worst possible scenarios and rebuild a portfolio, cash and Treasuries should already be the game plan and hopefully is).

Here is an article that makes the case for "the worst is yet to come". The comparison, which I respect very much and might end up being true, is that we are at 1937 but with the 1930-32 plunge of 90% from top to bottom to come. The author makes the case that since so far a complete crash has been forestalled by government intervention, it must still be in our future. Of course, in the 1930-32 period, Hoover did try hard to stop the market and economic plunge, but his advisors had little historical insight to work with and none of the Federal and State social safety nets we have today. History has shown us the Hoover administration did much too little, too late to stop the plunge. Because the market and economy fell so far and so hard, it took 10 years to rebuild.

I take on faith (we don't really know if it will work) that the Feds can backstop the economic decline. It is one grand experiment we are all living. But the naysayers don't know any better that the decline can't be stopped. They are no more believable in their claims. And haven't most of the people that should go to cash already done so? The rest of us should wait it out, if we can afford to do so. Pulling out enmasse will just make problems worse as it would further collapse the capital base in the economic system. This is one of the logical fallacies of the Bears. They make the case everyone should get out because the market is about to fall. But it is the panic selling that drives the markets lower. If everyone stays put, becomes more optimistic and holds on, the market CAN'T fall. We will see if Obama and his team can change mass psychology and eliminate the panic impulse that creates Depressions. My bet is they can. But if they can't, I will wait patiently for the fever to run its course.

Here is the article with its accompanying charts.

http://www.howestreet.com/articles/index.php?article_id=8243

Buffett Believes in America, Shouldn't We?

This editorial from the NY Times has already received a lot of public attention. But in case you did not have a chance to read it in full, I thought I would make it available to you. I have my arguments with Buffett on his politics, but regarding his investing acumen, there is no doubt.

If American stocks are good enough for him now, they are certainly good enough for me. So I am 100% invested in the stock market as of today, mostly large cap, secure and high dividend producing stocks and mostly in the energy / commodities space, since I am fairly certain we will have price inflation in commodities when the economy rebounds.

"Buy American. I Am. "
http://www.nytimes.com/2008/10/17/opinion/17buffett.html

By WARREN E. BUFFETT
Published: October 16, 2008

THE financial world is a mess, both in the United States and abroad. Its problems, moreover, have been leaking into the general economy, and the leaks are now turning into a gusher. In the near term, unemployment will rise, business activity will falter and headlines will continue to be scary.

So ... I’ve been buying American stocks. This is my personal account I’m talking about, in which I previously owned nothing but United States government bonds. (This description leaves aside my Berkshire Hathaway holdings, which are all committed to philanthropy.) If prices keep looking attractive, my non-Berkshire net worth will soon be 100 percent in United States equities.

Why?

A simple rule dictates my buying: Be fearful when others are greedy, and be greedy when others are fearful. And most certainly, fear is now widespread, gripping even seasoned investors. To be sure, investors are right to be wary of highly leveraged entities or businesses in weak competitive positions. But fears regarding the long-term prosperity of the nation’s many sound companies make no sense. These businesses will indeed suffer earnings hiccups, as they always have. But most major companies will be setting new profit records 5, 10 and 20 years from now.

Let me be clear on one point: I can’t predict the short-term movements of the stock market. I haven’t the faintest idea as to whether stocks will be higher or lower a month — or a year — from now. What is likely, however, is that the market will move higher, perhaps substantially so, well before either sentiment or the economy turns up. So if you wait for the robins, spring will be over.

A little history here: During the Depression, the Dow hit its low, 41, on July 8, 1932. Economic conditions, though, kept deteriorating until Franklin D. Roosevelt took office in March 1933. By that time, the market had already advanced 30 percent. Or think back to the early days of World War II, when things were going badly for the United States in Europe and the Pacific. The market hit bottom in April 1942, well before Allied fortunes turned. Again, in the early 1980s, the time to buy stocks was when inflation raged and the economy was in the tank. In short, bad news is an investor’s best friend. It lets you buy a slice of America’s future at a marked-down price.

Over the long term, the stock market news will be good. In the 20th century, the United States endured two world wars and other traumatic and expensive military conflicts; the Depression; a dozen or so recessions and financial panics; oil shocks; a flu epidemic; and the resignation of a disgraced president. Yet the Dow rose from 66 to 11,497.

You might think it would have been impossible for an investor to lose money during a century marked by such an extraordinary gain. But some investors did. The hapless ones bought stocks only when they felt comfort in doing so and then proceeded to sell when the headlines made them queasy.

Today people who hold cash equivalents feel comfortable. They shouldn’t. They have opted for a terrible long-term asset, one that pays virtually nothing and is certain to depreciate in value. Indeed, the policies that government will follow in its efforts to alleviate the current crisis will probably prove inflationary and therefore accelerate declines in the real value of cash accounts.

Equities will almost certainly outperform cash over the next decade, probably by a substantial degree. Those investors who cling now to cash are betting they can efficiently time their move away from it later. In waiting for the comfort of good news, they are ignoring Wayne Gretzky’s advice: “I skate to where the puck is going to be, not to where it has been.”

I don’t like to opine on the stock market, and again I emphasize that I have no idea what the market will do in the short term. Nevertheless, I’ll follow the lead of a restaurant that opened in an empty bank building and then advertised: “Put your mouth where your money was.” Today my money and my mouth both say equities.

Warren E. Buffett is the chief executive of Berkshire Hathaway, a diversified holding company.

Back to Reality

I was at my annual boys golf tournament the past 3 days. We call it "Party At The Pines" at a resort in northern Minnesota. This is the 14th year we have gone north with 16 or 20 guys and played non-stop golf for 3 days. It is a great way to get away from it all. You can't think stocks or trouble at work, when you are focused on hitting that little white ball about 400 times over those 3 days.

Now that I have missed all the stock market fun this week, I have a little chance to consider what has happened and where we go from here. One thing is for sure, the market has left its moorings. It has entered the irrational phase when anything can happen. The one thing I know from all the reading I have done, is that at times like this, it is best to just stand still and do nothing.

I am not a disinterested bystander, by the way. I thought I was fairly well protected from this eruption (which I suggested was a possibility as early as 2005, based on the housing bubble bursting), but I have been more or less fully invested since I believe it is impossible to pick a bottom. And honestly, this market situation is at the extreme end of what I thought was possible. There has always been a doomsday scenario suggested by some analysts, that would be triggered by this type of loss of confidence in the financial system. But I never really thought it would go as far as it has.

You know that I have been buying high dividend stocks and funds and reinvesting the large dividends in the same stocks to average down my cost if the price goes lower. I am very diverse in my holdings so that the risk is spread. But still I am getting hurt badly in this market because even the babies are now getting thrown out. Even cash is no longer safe, as some big money market funds are now "breaking the buck" and unable to return $1 of principal.

But this has all the look of capitulation. VIX peaked at near 40 today, which is its highest level since the 2000-03. Generally any spike over 30 signals fear in the market and a buying opportunity, though note how long high market volatility went on in the Tech Bust:



What needs to happen to change the direction of the market? There are a few basic actions to look for. The basic need is to break the vicious feedback loop in which the market is now engaged. The actions need to come from the government as they are regulatory in nature and in most instances, the government initiated the rules or regulations that have precipitated this crisis.

1. Suspend the "Mark-to-Market" rule: It came out of Sarbanes-Oxley legislation and was implented by the accounting board, FASB. Mark to Market is the primary culprit for circular market action, since the action of marking down assets weakens the capital structure of a bank and causes it to decline in value. As assets decline in value based on the weakness in the institutions backing the financial assets, the market price declines requiring another round of markdowns. This has gone on until some banks have broken their statutory capital requirement level and become insolvent in the process. This must stop to repair the market, so look for a loosening here and the option of "Marking to Model"

2. Clamp down on short selling: Although I have been doing some short selling to provide protection, and believe in it from a free market perspective, but it can really exacerbate the snowball effect of a downward spiraling market. Because financial institutions use the equity on their balance sheet as capital against their book of bank financing, they are exposed to damage by short selling more than other businesses which don't leverage their equity to do business. The "uptick" rule should be reinstated and I see that there are further restrictions on Market Makers put into effect by the SEC today so that shorts have to have claim to the physical stock in order to short it (that is, no naked shorts).

3. Continue infusing liquidity into the market: The Feds need to continue flooding the market with capital so that the financial engine does not seize up. Money is like a lubricant to financial institutions and business in general. If it ever stops flowing, then business freezes. The Feds have many ways to put money back into the financial markets.

4. Back more institutions with capital as needed: AIG and Fannie/Freddie were both bailed out with large US government loans. But these are not necessarily bailouts that will cost the taxpayer over the long term. This is the modern equivalent of the Resolution Trust Corp (RTC). The Feds are giving capital loans at a high percent interest ($85B at 12% in the case of AIG). This paper can later be sold on the open market at a big profit once the market panic passes and the company's balance sheet is repaired, just as any bond can be sold.

Goldman Sachs (GS) and Morgan Stanley now look like the two that need the most help, though they were thought to be top of the heap a few weeks ago. GS just beat expectations with its earnings report on Tuesday. Apparently their CDSs (credit default swaps which are like loan insurance) sold to other banks to hedge risk in loan portfolios, are jumping in cost. The Fed can help them here by buying the CDSs onto the Fed's balance sheet and later reselling to the market at a profit, to the taxpayer's benefit.

Even though they have so far avoided attack by the short sellers, USB and Wells Fargo are not out of the woods. In this market, the shorts can ruin any bank.

5. Coordinate Central Banks globally to take a similar approach with their own national banking companies. There is so much linkage in the financial system this is not an exclusively American problem, though it may have started here. The Central Bankers should be talking to each other (I am sure they are) to coordinate actions for the maximum positive effect. The Euro can be used to prop up European banks and the Chinese and Japanese central banks are flush and should do the same for their home banks.

6. The Central Bank should not worry about inflation right now. Everything happening right now (not 6 months ago) is Deflationary, not Inflationary. Financial contraction, in terms of deleveraging of financial institutions and dropping real estate prices, is inherently deflationary. The Fed can pump as much money into the banking system as it wants without adverse effects today. Once there is recovery, the Fed then would need to take money back out of the financial system by calling its loans, or selling them off.

7. Shut down the ratings agencies: Moody's, S&P, and other ratings agencies are doing more harm than good. They were big contributors in blowing up the real estate bubble by rating sub-prime securities as AAA, thereby attracting cheap money from abroad into our housing market. And now they are over-reacting the other direction and are dropping ratings on good companies because their stock price is declining and it is decreasing capital ratio coverage (see points 3 and 4). The function of agencies is to provide constructive guidance to investors based on their research departments. But the agencies have not lived up to that promise for more than a decade. They missed the Tech Bust as well.


8. Finally, remember that when the market does get over its panic, the rebound will be substantial. It may not bounce back to 14,000 Dow anytime soon, but it could bounce back to 12,500. The Financials that are left standing can double or triple over a 6-12 month period as they regain the irrational / non-fundamental losses. So, financial index UYG, as one suggestion, will do very well at some point.

I hope Bernanke and Paulsen work quickly on the above, plus anything else they can think of that I have not. They need to do so to keep us from crashing into a Depression. I think we have the right people at the top to avoid a real crash with Bernanke an expert on deflations and Paulsen an expert on investment banking finance. Watch for any or all the above and when you see action taken, it should solve the problem.

Until I see what comes from the Fed, I am sitting on my hands trying to avoid doing any more damage to my accounts by selling low, but also not sure if we are at the bottom, so not willing to buy, other than through the methodical reinvestment of dividends that I have set up.