Tuesday, July 22, 2008

Investment Discipline

“History is merely a list of surprises. It can only prepare us to be surprised yet again.”
Kurt Vonnegut
Having experienced a multitude of market crises, I realize that history never repeats itself exactly, so I’d be arrogant not to admit that almost anything can happen from here. It is a distinct possibility that things will get worse before they get better in the stock market. Even if the economy holds up, fear and pessimism could cause of investors to panic and send the market down further than justified by long-term economic fundamentals.














































At times like this, it is essential to have a sense of perspective and rely on sound long-term investment disciplines when making decisions. It is important to avoid panicking because of short-term market concerns and uncertainty. It is easy to put too much weight on negative scenarios when all you hear is bad. Inevitably, investors always flee the stock market at just the most inopportune moment, when the tremendous bargain basement deals are obtainable. I love the chart above because it shows how the average equity investor underperforms the markets. He has only earned 4.5% per year over the last twenty years due to emotional trading. Over the same 20 year period, the S&P 500 domestic stock index earned 11.9% per year and the bond market earned 7.9%. The average equity investor missed out on these returns by fleeing the market at the low and re-entering when it has already recovered. Dalbar Inc. calculated the average investor’s performance using net aggregate mutual fund sales, redemptions and exchanges by month for twenty years.
Bubbles lead investors to make errors in judgment, thereby mispricing assets on the way up. Investors do not understand the risks they are taking and what could happen. On the flip side, riskier assets often fall to bargain prices on the way down when investors are frightened. The risks become clear: investors panic when losses start to accumulate and flee the market. This pattern of overzealousness-followed-by-panic repeats throughout the history of mankind.
While the perspective gained from years of experience is useful, humbleness is just as important. It is crucial to always be open to market signals and stay intellectually honest about factors you can and cannot assess. Or else you will miss when the market is warning you that it isn’t the normal boom-bust cycle but a full scale melt down. I spend hours assessing risk, global economies and investment markets. I try to communicate what I have learned to you through my blog, newsletters, phone calls and meetings. At this point, this is a normal bear market. Fleeing the markets now would be a big mistake since stocks are priced to outperform bonds over the next five-years. Second, big market downturns invariably present opportunities - you just have to have conviction.
Since 1946, there have been nine bear market declines of 20% or more. The average drop was 32.5% over 14 months. The average bull-run lasted 70 months, with average returns over 185%. While this does not guarantee future results, it certainly provides food for thought. With major indices down about 20% from their October 2007 peaks, it would not be surprising to see the markets fall another 10%, at least from the perspective of history. Many traders are now referring to 2008 as the Year of Capitulation.
It has been a tough first half, and even some legendary money managers have taken a hit. GuruFocus.com follows the trades of legendary money managers and keeps track of their results over 6-month and 12- month time periods. If you think your portfolios performance has been dismal, you may take some consolation in seeing how many Managers of the Year and other top-notch investors have been (Marty Whitman down 43%). Even Warren Buffett is now in negative territory for both the 6 and 12-month periods just ended. Warren has a great perspective on market down turns. He said at his recent shareholder meeting, “If a stock [I own] goes down 50%, I’d look forward to it. In fact, I would offer you a significant sum of money if you could give me the opportunity for all my stocks to go down 50% over the next month.” Mr. Buffett wants the price to decline so he can buy more cheaply. I wouldn't bet against any of these guys rebounding in a big way once the market picks up in the future.

Monday, July 21, 2008

Week in Review

As a result of good news last week, stocks were able to break their multi week losing streak. A combination of stronger than expected earnings announcements, introduction of the governement's plan to save Fannie Mae and Freddie Mac, short covering and outright buying in the financial sector and a sharp correction in oil prices. The S&P 500 rose 1.7% to 1,261, the Nasdaq climbed 2% to 2,283 and the DJIA increased 3.6% to 3.6% to close at 11,497. Financial stocks led the way, advancing over 11% while energy, utilities and materials all declined. Inflation worries still pursist but falling oil prices will add some stability to the stock and credit markets.

Bonds - Why do we own them?

Bonds are worth owning. Yes, the credit markets are a mess and bonds did fall in value during the Second Quarter 2008 but bonds offer stability. Bonds are much less volatile then commodities, stocks and residential real estate. See the adjacent chart. Bonds have a standard deviation of only 1.1% while oil's is over 9%. Standard deviation measures how scattered the returns are from the average. The more variation the higher the standard deviation. The down side is bonds earn less than stocks. So even though stocks are more risky in the long run they generate a higher return.
I view bonds as an insurance policy. How much long term return do you want to give up to gain stability? You are essentially buying an insurance policy for your portfolio the way you would for your home. In the case of property insurance, the question is how much current income are you willing to spend to protect you home from a catastrophic event. You are never going to make as much money invested in bonds instead of stocks. So how much do you need to invest in bonds to protect your portfolio from a catastrophic event? That depends on whether you need the money now or are years away from retirement. It depends on how well you can handle short term market swings. It depends on how much money you have and how much money you'll need and when. So the answer is it depends on your needs and your money personality. In other words, there is no magic formula. So it is important to carefully address all these issues when determining your allocation to bonds.

Friday, July 18, 2008

Short Selling

In order to bring more stability to the stock market the SEC acted this week to retrict naked short selling. Here are three good stories on NPR (National Public Radio) that discuss who, what and why of it all.

Short-selling-profiting-from others misery

What-is-naked-short-selling

SEC Cracks down on naked short selling

Thursday, July 17, 2008

Global Focus is Now Chic

Look whose going global! First it was California Public Employees Retirement System (CalPERS) and now it is California's other big pension fund California State Teacher's Retiriement System (CalSTRS).

The proposal by CalSTRS' staff reflects a greater interest by institutional investors to move from a home-country bias and have their equity portfolio reflect the broader global market. CalSTRS could move some $15 billion to overseas equities from domestic stocks if its investment committee approves.

At Altamont Wealth Management, we have been actively shedding our home country bias and moving towards a global allocation for two years. It is great to hear that the large institutional pension funds are catching up.

Going-Global

Wednesday, July 16, 2008

Second Quarter Market Review

"You make most of your money during a bear market; you just don’t realize it at the time." Shelby Cullom Davis

The first half of the year had all the thrills and chills of a bad horror flick. There were nauseating triple digit declines in the U.S. market, warnings of collapse among players in the global financial system and the subprime-mortgage-housing foreclosure crisis debacle. Then we had a rally in early spring and investors breathed a sigh of relief as many believed that the subprime monster had been tamed and the worst was behind us.

Ah, but never underestimate a bad horror movie. There was more than just one monster in this picture. The oil monster was on the rise and he scared consumers out of their SUVs. His pal, the inflation monster, also caused fear as he caused food prices and healthcare costs to rise. In response, the markets ran scared and fell hard again. These last two monsters, oil prices and inflation, delivered a one-two psychological blow to the markets. Investors had been lulled into feeling safe by the early spring rally that had pushed the market averages into positive territory for the year. Of course, everyone knows that you can never be safe until the hero, Obama or McCain, captures the monsters and saves the economy. But I am getting ahead of myself; let’s first talk about the second quarter.

So a sharply negative first quarter was followed by two months of positive returns, but the selloff resumed with a vengeance in June, with large-cap stocks dropping over 8%, resulting in a 3% decline for the second quarter. Surprisingly, Mid Caps and Small Caps hung on to have a positive quarter with the S&P400 Mid Caps rising 8.7% and the S&P 600 Small Caps up 3.5%.

Value stocks fell across the board, which is not surprising since the financial, mortgage and housing stocks are all in bad shape. Conversely, Growth stocks were positive across all market caps. Domestic high-quality bonds were down just over 1% for the second quarter and up just 1% for the year. Though not a good return in a normal environment, bonds did provide balanced investors with a modicum of protection from stock-market losses, which is part of their role.

Being diversified outside of U.S. stock market didn’t help much. Developed international markets fell 2.3% for the quarter and are down almost 11% year-to-date. Emerging markets were positive for the quarter earning 2.2% but are still down almost 10% for the year.

Interestingly, international bonds have performed well this year. They are one of the least risky ways to profit from the declining dollar. Emerging market debt has performed admirably, reflecting the rise in third world countries on the economic world stage. PIMCO Developing Local Markets was up 3.3% over the quarter and 5.8% year-to-date. PIMCO Foreign Unhedged that invests in developed countries was down 5% for the quarter but still up 5% for the year.
The only relief domestically was in the commodities markets which have profited from rising food, metal and oil prices. Unfortunately, commodities look like a speculative bubble that is going to pop.

Monday, July 14, 2008

Last Week in Review, Market Shorts at Bearish Levels

Another icky week and more worries. Once again stocks declined last week in the face of credit concerns, recession worries, high oil prices and inflation fears. The S&P 500 fell 1.8% during the week to 1239. we are firmly in Bear territory now.

As we have discussed before the Fed is between a rock and a hard place. It cannot serve dual mistresses of low inflation and economic growth. So in order to keep the peace it will have to keep the Fed funds rate at 2%. It will continue to aggressively use what ever tools it has at its disposal to create liquidity and fight off market instability. We will continue to see the Fed step in as necessary as it did this weekend to provide liquidity to Fannie Mae and Freddie Mac.

The next chart highlights the amount of short interest in the market today. This measure depicts the percentage of trading volume that is betting the market will go down. Historically, levels this bearish have been fore bearers of future market rallies.

So what is the outlook from here? Presently, the U.S. equity market is in the process of making its third bottom (the first occurring in mid-January and the second in mid-March). The next notable move will probably be up as fears begins to abate.
As long as oil prices keep rising, stocks will remain under pressure, central banks will be unable to act and the risk of recession will grow. In the long term, for the markets to recover will require oil prices to abate which means the demand for oil must subside. Demand pressures should subside as the global economy continues to slow. It will become ever more difficult for oil prices to continue their unprecedented drive higher as demand pressures abate. The bottom line is that a correction in oil prices is a necessary if the world economy is to avoid a major slump, for inflation to decline and for equity markets to enjoy a sustained rally. At this point oil prices haven't shown any weakness so it is unclear when things will begin to get better.

Monday, July 7, 2008

Credit Reporting Agencies: Errors, Impacts and Problems

If this can happen to a well known reporter on NPR then it can happen to you!

Terry Gross and her husband recently had a tusssle with credit rating agencies when they assigned credit problems inadvertently to her husband. They had to hire an attorney to help straighten out the mess with the rating agencies.

Terry discusses the impact of credit agencies on our lives with Prof. Elizabeth Warren, a specialist in bankruptcy and contract law at Harvard Law School. It is a very informative discussion.

http://www.npr.org/templates/story/story.php?storyId=92049490

Thursday, July 3, 2008

Bruce Berkowitz, Manager of Fairholme

Here are some comments made by Bruce Berkowitz, Manager of Fairhome at the 2008 Morningstar Conference in Chicago last week. He addresses potentially closing his fund, the recent change in the fund's charter and the future of his fund. These remarks were made after he had spoken on a panel.