Friday, October 24, 2008

Here comes the money

Except for the not inconsequential fact of the market falling another 500 points, the week of October 20 wasn’t too bad.

More companies and municipalities were able to issue bonds, and more businesses were able to re-establish lines of credit with their banks. Another major bank (National City) went off the air without depositors or bondholders losing a penny as it was merged into a more healthy rival (PNC Bank).

The leading economic indicators for September were +0.3%, which gives some credence to my thoughts that the economy was about to turn the corner and move on to recovery just prior to Lehman Brothers going bankrupt and the financial scare sending the stock market down another 1,500 points.

Existing home sales also surprised on the upside, suggesting that perhaps the economy is starting to work toward balancing higher demand due to lower prices with escalating supplies due to the foreclosure problem. I don’t think the housing market has turned the corner, but sometimes just a small improvement at the margin (we not getting worse anymore!) can make a significant difference.

I still applaud the Federal Reserve, and to a lesser degree the Treasury, for their aggressive response to the crisis. We will definitely look back at this time period and have some criticisms. Did the taxpayers really just give Goldman Sachs $10 billion so that they could pay out obscene bonuses to the "Masters of the Universe" who engineered the recent collapse, or will Warren Buffett put a stop to such nonsense because he, too, needed to pony up to the bar to keep Treasury Secretary Paulsen's alma mater afloat?

Peter Fisher, a BlackRock Managing Director, noted that we may look back and conclude that Bernanke and Paulsen erred in March by issuing a public warning that all banks need to go out and raise more capital. "The only thing worse than yelling fire in a theatre," Fisher said at a recent Conference on De-leveraging, "is having the Fire Marshall do it for you." By the time that Lehman failed and the financial crisis began in earnest, the financial markets were primed with an unprecedented amount of fear. It's not clear that this climate could have been avoided. On the other hand, had the Lehman failure been contained (as was the Bear Stearns bailout), who knows what pain might have been avoided.

The market has re-tested its October 10 low, and thus far it has held up. It is a fragile victory at this point, but an important one. It seems to me that the U.S. market wants to bottom, but the global market sell-off, which now exceeds the U.S. market plunge, may not let it. If the foreign markets can't catch a bid, the current bottom may not hold.

In the meantime, we're probably going to get another round of interest rate cuts across the globe. Next week, the Treasury will start buying commercial paper (very short-term bonds) of real businesses - to enable companies that actually make and sell things to keep people working. Thus far, the banks are mostly sitting on the money they've (just) received from the Federal Reserve. They're using it to "de-leverage" their balance sheet, rather than using it to make new loans. They're using it to take over other failed institutions. They're using it to pay down debt. We need it to find it's way back into the economy. Perhaps General Electric, which has said that it will take advantage of the new Treasury program, will use it to pay down some accounts payable so that Joe the Plumber has some money next weekend to go out to eat.

The money from the Treasury is starting to flow into the system. However, in econ-o-speak, what has also happened is that the "velocity" of money has dropped considerably. People have a bit less of the green stuff, but even more importantly they're afraid to spend it because of the lingering uncertainty. Economic activity can come to a standstill if no one is willing to spend what they've got. At the bottom of the 1933 Depression, at his inaugural address, Franklin Delanore Roosevelt said, "the only thing we have to fear is fear itself." This problem, fortunately, is not structural - but rather psychological. After 9/11, the nation was similarly paralyzed. I would expect a similar economic reaction for the balance of 2008 and into 2009. There will be a sharp slowdown, but it need not result in economic disaster if the global selling can be contained and people gradually return to more free-spending ways.

In the future, the most leveraged companies and individuals will have to adjust. The de-leveraging of America has begun and will likely last for several years. Some of the adjustments will be painful, but a doom and gloom forecast suggests that the economy will come to a standstill and remain there for a long period of time.

I have more faith in the Fed than that. The Federal Reserve is bound and determined to get money back into the system to offset some of the wealth destruction that has occurred. Though Greenspan should have taken away the punch bowl a few years back, before the real estate market began to froth, now the punch bowl is back, full, and the government is handing out chasers to anyone near the front door.

So, does that mean we're about to put our remaining reserves back into this market? I'm now on my third week of waiting and watching, mostly. We went into individual portfolios to rebalance the current positions which, given the severity of the sell-off, left some positions under-represented while other, more defensive holdings (which hadn't sold off as quickly) were over-weighted. We evened out the weightings, but still have cash in reserve which we're hoping to reinvest while there is still upside to the market.

I've been digging deep into my research files to confirm that stocks go both ways, both down and up. It's getting hard to remember that, some days. As the money returns to the economy and nerves settle, I expect that we'll soon be reminded of the good side of stock volatility.

Douglas B. May, CFA, is President of May-Investments, LLC and author of Investment Heresies.



Friday, October 17, 2008

Plus or minus?

This week set a new record for the volatility index, though the wild swings to the plus side were offset by plunging prices into minus territory. By the end of the week, I was left with a market little changed, but we’re seeing many tiny signs of improvement in the state of the financial world. I would much rather buy the Dow Jones Industrial Average at 8,852 today (Friday) than when we were at similar levels last Monday.

The typical investor tends to underestimate volatility, though it may be a generation before they make that mistake again given the recent 100-year flood of volatility we’ve just experienced.

Standard deviation” is one measure of volatility. Over the long haul, the typical standard deviation for the market is almost 20%. That is the percentage by which the market will “typically” (19 times out of 20) deviate from the normal return. Many people hear a 20% standard deviation and, given a “normal” return to stocks of 10%, form a mental picture of the market swinging from 0% to 20% during most years. This underestimates normal stock market volatility. Forbes columnist, Ken Fisher, wrote a fantistic piece explaining how most people underestimate volatility, but unfortunately I didn't save it and I haven't been able to Google it to provide a link.

During some periods, like what we just experienced, the market may swing from 20% overvalued to 20% undervalued, for a top-to-bottom 40% swing. This is normal for the market, probably once every 20 years.

One reason to take this crash all in stride is because that’s just what markets do. They crash, and they soar, and when volatility is high sometimes the plusses and minuses balance each other out and you get a market like the one this week where the market moves more in a day than it typically moves over the course of a year, but with no significant move overall. The key to understanding volatility is to try to make the best of it. It is almost always the case that the worst thing you can do is let downside volatility frighten you out of the market.

Don’t get me wrong. We’re not in a “normal” market. We just experienced the worst crash in 100 years of U.S. stock market history. However, some context is important. And, to some degree, this is just what markets do.

Almost exactly a year, the Dow Jones Industrial Average peaked at 14,169. Assuming that it was 20% overvalued on that day, it would put “intrinsic value” for the Index, last October, at about 11,800. A year later, Bear Stearns and Lehman Brothers have disappeared from the scene and the market (hopefully) “bottomed” on October 10th at just below 7,900. Assuming that it was 20% undervalued on that day, “intrinsic value” for the market would be about 9,875.

Intrinsic value isn’t supposed to move around much. Intrinsic value is supposed to be fixed, while stock prices move around. Could intrinsic value possibly have fallen 17% from 11,800 to 9,875 in only a year? In my view, given the severity of the financial crises, the interventions required to halt the panic, and the long-lived repurcussions we will feel, the answer is yes.

In my opinion, it’s not the sub-prime mortgage mess that brought the economy to its knees, but rather the myriad of derivatives contracts and credit default swaps that acted as an accelerant and caused the fire to sweep quickly through to all banks and insurance companies, and which eventually caused the bond market generally to cease to function. When good companies couldn’t refinance their debt because no one knew how much counter-party risk anyone else has, our economic system ceased to function.

When the show trials begin, my hope is that it is these Wall Street casino operators who originated hundreds of trillions of dollars of investor-to-investor wagers who will be doing the perp walk. It is these “financial engineers” who made their fortunes building the current disaster. They collected their cut up front and have left the U.S. taxpayer on the hook for bailing out the system that they came all too close to destroying.

We are just now beginning to see some functions restored. IBM issued bonds last week. They were the first company to be able to do so since September 2nd. There were a couple of other new issues priced and sold, this week. The bond markets are starting to function again. We’re beginning to see banks re-extend lines of credit to some borrowers. The European banks have reduced, ever so slightly, the premium they’ve been charging to risk making loans to their American counterparts. We’re starting to see signs of life. There is still a lot of recovery that needs to happen.

The damage hasn’t been limited to the United States, of course. Foreign markets have plunged as well. To me, the falling value of oil prices has been a proxy for fears that the world economy will sink into the abyss. I think there are other things going on as well. Thanks to the casino operators, investors no longer trust paper assets. Ultimately, gold futures are paper assets. I think that commodity prices are depressed partly because investors are unwilling to speculate in derivates until we know which counterparties are going to survive to expiration day. I am reading that in some physical delivery markets, prices take place at a premium to the “spot market” (futures) price, and that vendors are far behind in being able to make physical delivery (i.e. there are shortages). The real economy maybe isn’t in as bad a shape as the futures markets are telling us. Maybe, what’s in really bad shape, is merely the futures markets themselves.

We continue to have money on the sidelines, available to invest in the market at much lower levels than a year ago. Ultimately, getting back some of what has been lost requires a willingness to invest. I have been willing to wait for some signs that things are getting better before being willing to commit capital to this market. I am relieved to see signs that things are turning up. By the time it is clear beyond a shadow of doubt, it will be too late.

If “intrinsic value” truly lies around 9,875 (for the sake of argument), the market could easily rally to the 10,000 to 11,000 level and stay well within its traditional volatility range of +/- 20%. We won’t be able to take advantage of this volatility if we’re still on the sidelines. The pressure, at this point, points toward getting back into the market so that we can take advantage of upside volatility before it’s too late.

Liquidity is returning to the market. Oil prices are stabilizing, suggesting hope for the global economy. Third quarter earnings, outside of the financial sector, haven’t been too bad. Patience paid off this week. However, I probably don’t have a lot longer before the plusses outweigh the minuses and this market takes off to the upside.

The economic statistics will get worse before they get better. The stock market, though, may have already factored in the “worst case” scenario. Hopefully we will start seeing volatility work in our favor. It may not signal a new bull market, but some recovery would be nice and it seems like we’re about due.

Douglas B. May, CFA, is President of May-Investments, LLC and author of Investment Heresies.



Friday, October 10, 2008

After Capitulation, What?

Now that we’ve passed through all the valuation floors and fear dominates not only the trading floors, but the nation’s psyche as well, there’s no doubt we’ve reached the capitulation stage where investors surrender to fear, sell at any price (no matter how irrational) just because the pain of watching it go lower is too much to bear.

Capitulation is normally a one day sort of affair. What has made this one the worst in a century is that it has lasted for several days.
  • What’s next?
What typically happens next is that investors realize that General Electric still needs to manufacture gas turbines, Chevron still needs to bring gasoline to a nation of drivers, and Safeway still needs to deliver food to a hungry nation. Commerce needs to go on. Furthermore, stocks purchased during this sort of sell-off typically rebound to the benefit of investors. In the 5 instances since 1970 when stocks have sold off 18% or more within an 8-week period, the market was up an average of 15% six months later. The essence of “buy low, sell high” is to invest during these troubled times.

There are many reasons to be more optimistic than the market (which isn’t saying much) from this point. First, the Fed and the Treasury Department have been very proactive in trying to get money flowing again. I have a list of more than a dozen major efforts to stimulate the economy using methods that just six months ago I would have thought impossible (and probably unconstitutional). These are steps taken save bondholders and depositors, to keep the doors open on companies determined to be “too big to fail,” and to get the bond markets moving again. The government has nationalized Freddie Mac and Fannie Mae, offered private equity financing to AIG, forced Bear Stearns and Wachovia to sell themselves to competitors, bailed out IndyMac Bank depositors, re-regulated the Fed discount window to give Goldman Sachs access to the government storehouse, insured money market fund deposits, arbitraged 0.75% T-Bill rates in order to buy much higher yielding commercial paper…and the really creative stuff has yet to be announced. Just think of the ideas that didn’t make it into the final plan!

In recent days, other nations have joined the effort with the European Central Bank, the Banks of England and Canada, the Swedish Bank, Hong Kong, China and others cutting interest rates and putting capital into their own private banking companies. Australia cut rates by 1%. Moreover, longer-term interest rates are falling internationally, which will eventually help get things moving again.

The bailout bill boosted FDIC insurance so that worried investors would bring money into the banking sector, rather than taking it out (as happened during the depression). The Treasury’s latest proposal, to invest directly into banks through buying preferred stock, may be ten times more effective than simply buying sub-prime assets off the bank’s books. The notion of the U.S. Government investing directly in U.S. companies through the purchase of commercial paper (very short-term bonds) could be extremely helpful, but all of these steps take a few days to get started and the market has never been known for its patience.

There’s no doubt that capitalism and “free markets” have a big, black eye. There will be many opportunities to place blame, at some point in the future. For now, though, the objective is to (as Warren Buffett said a few days ago in a great Charlie Rose interview) get the cardiac arrest patient up off the floor and moving again. There will be ramifications for the actions we’ve taken. However, the consequences of doing nothing would have been much worse.

Based on valuations, investors should buy stocks today. Unfortunately, based on valuations alone the rally probably should have started at least 2,000 points ago. For the most part, what I’m waiting for is some sign that all this money that the Treasury is putting into the banking sector is beginning to find its way into the hands of the businesses that need it. I need the bond markets to start functioning again, so that a sound bank or insurance company (if that’s not an oxymoron) will be able to roll over maturing debt on reasonable terms to the lender.

I am hearing that some institutional money market funds have closed to new deposits (of $25 million or more) because they don’t have any place to invest it. Commercial paper issuers have withdrawn from the market, or perhaps those funds are choosing to buy only Treasury Bills, but they cannot find enough bonds/notes in the market to invest new money. That is a great sign. Liquidity may be starting to pile up on the sidelines.

There are many reasons to be optimistic from here. Fear is the investor’s enemy. Where has the “don’t fight the Fed” crowd gone? Or the “lower oil prices are good for the economy” bunch?

I remain focused on how to take advantage of the sell-off by buying back in. When we get past this frightening phase, the market should be higher. I, frankly, don’t want to wait too long to buy. However, I do want to see signs that the massive liquidity add is having an impact before committing capital.

Douglas B. May, CFA, is President of May-Investments, LLC and author of GJretire.



Monday, October 6, 2008

2006 Economic Forecast Update

In our October 2006 Economic Update luncheon for clients, we expressed fears of a 30% market sell-off, comprised of a 20% decline in earnings and a reduction in the Price/Earnings ratio from 16X earnings to 14X earnings. From the 2007 peak, this 30% sell-off would have taken the market down to 1085. If you start from where the market was in October 2006 (1350), the 30% sell-off would take the market down to 945 on the S&P 500 Index.

Today the market hit (bottomed out at?) 1008 and closed at 1056, above the October 2006 projection but below the October 2007 peak-to-trough forecast.

Furthermore, the sell-off resulted from the real estate problems that we highlighted in October 2006. The trepidation we felt in 2006 is now widely shared. The recession is no longer an intellectual construct, but rather a day-to-day (if not hour-by-hour) headline.

Today’s liquidity crisis is worse than we’d anticipated. In any case, it feels worse than we were prepared to feel. However, if psychology can pinpoint a market low, then it can’t get much worse than this. If I were going on psychology, alone, this would clearly be a buying opportunity.
  • So what have we done about it?
All we’ve done, recently, is put new money to work. Accounts that brought in new cash in the past month may have had more money sitting on the sidelines (thankfully) than most, and those reserves have now been invested.

Most portfolios, however, still have money on the sidelines waiting for the market to turn around. In fact, at this point the trades are loaded and we’re just waiting for the right opportunity to invest.

I’ve been looking for a big sell-off (1,000 points down on the Dow) with a spike in the volatility index for a couple of weeks, now. We haven’t seen that magical combination, though the Dow sank 777 points last Monday, and was down over 800 points at one point today. Also, we’re down well over 1,000 points since I first started looking for that sell-off.

Stocks are very cheap, as compared with bond yields. Some market bloggers are speculating about the “mother of all snapbacks” when this sell-off ends. It could be that my volatility spike will come on the upside, rather than the downside. Woudn’t that be nice!
  • What might make us buy?
In addition to this painful exercise of “how low can it go,” I’m looking at a couple of specific indicators for a signal that the tide is ready to turn. Signs that the liquidity crisis is lessening, or that the markets have completely priced in a global recession, would signal a reasonable re-entry point. The market is now off more than 30% from its high. Financials stock prices have been cut in half. The commodity sector has experienced its worst sell-off in 50 years (since 1956). Clearly, now is a better time to buy stocks than it was a year ago (when most investors were far more willing to do so).

The liquidity crisis will gradually resolve itself. The Fed and the U.S. Treasury are creating new and innovative ways to pump money into the system. After the 1987 crash, the Fed was on the phone with member banks, asking if any customers needed money (and indicating that the Fed was willing to make certain that they got it). I have little doubt that those same promises are being attempted today.

The Fed is paying interest on banking reserves that never used to receive interest. The bailout bill brings a new buyer into the market for hard-to-value (and liquidate) Level 3 assets. Last week’s bill also makes it possible for the S.E.C. to suspend mark-to-market accounting, and hopefully the S.E.C. will announce measures to that effect sooner rather than later, reducing the pressure on banks to dump assets. Raising FDIC insurance limits will hopefully bring in new deposits to the banks, increasing their balance sheet and hopefully the banks will be able to re-enter the corporate bond market on the buy side, since we haven’t seen many buyers, lately, even in that reasonably safe asset class.

Signs that the liquidity mess is beginning to improve might soon include lower corporate bond rates, higher junk bond prices, and lower spreads between Europe’s LIBOR rates and the U.S. Fed Funds rate, which signals the unwillingness of banks on the continent to lend money to its upstart brethren here in the New World.

I’m also looking for signs that the global recession has been fully priced into the global equity markets. In the last 3 months, Latin American stocks are down almost 35%, the Europe ETF has fallen about 20%. Japan is off nearly as much, and Asia stocks (ex-Japan) are down about 23%.

In my mind, the U.S. banking crisis bottomed out on July 15, and we’ve been trying to put a bottom in the liquidity crisis ever since then.

What’s caused the most pain recently, however, has been the gradual recognition over the past 3 months that the U.S. has exported its problems overseas. The world is now anticipating a global recession, and the commodity and international equity markets are adjusting rapidly to this new reality. The good news is that Central Banks around the globe are now preparing plans to add stimulus to offset the global credit crunch.

When we see the impact of these stimulus measures reflected in a stabilization of global energy prices, that will likely be an important turnaround point. At the end of the trading day, today, energy prices appeared to remain weak, even though the stock market rallied about 450 points off its low. Had energy prices been leading the way, I might have bought into the market. As it is, I thought it best to take another look at things tomorrow.

Though energy prices have certainly fallen recently, oil prices are still up 17% over where they were a year ago, and natural gas prices remain 7% higher. Stock prices in the energy sector are down closer to 20% over the same time frame. It feels like we’ve gone from a two standard deviation overvaluation in June to a two standard deviation sell-off event in September/October. In spite of this, the multitude of steps that the Fed is taking to get money into the financial system seems bound to put downward pressure on the dollar during the months to come, which generally puts inflationary pressure on the price of commodities.

Though we’ve bemoaned the high and rising energy prices in months past, I would really like to see energy prices stabilize just north of $100 per barrel. My guesstimate for “fair value” is actually around $115. If energy prices were to stabilize, I’d say that the global equity markets are starting to find equilibrium again and now reflect the unpleasant reality, which we first talked about late in 2006, that a recession is in the cards.

At times like this, it is sometimes hard to remember that what follows a “recession” is typically a recovery. Helicopter Ben (Bernanke), so-named because of a paper he wrote about preventing another depression hypothesized that ultimately the government could simply drop dollars out of a helicopter in order to get things moving again, is dead set on providing liquidity any way he can.

Whether or not today marked the bottom, I don’t know. In the long-term scheme of “Buy low, sell high,” however, I think we’ll find in retrospect that we’ve reached a buy point.

I decided to wait another day, for signs that the liquidity situation is improving, or that energy prices are ready to stabilize. We’ll see if “wait and see” proves to be a costly decision. Up until today, it hasn’t.

Douglas B. May, CFA, is President of May-Investments, LLC and author of Investment Heresies.