Sunday, October 26, 2008

Some Thoughts on the Stock Market

As we approach yet another week, I wanted to share some thoughts regarding
the recent volatility in the financial markets and what investors
should do going forward.

Until a few weeks ago, there were two significant groups of investors
out there. The "proactive" ones were those who rightfully determined
that our financial system would go through a major shock due to the
excesses of lenders and financial institutions and the "buy and hold"
investors who believe that you just buy good companies, be patient,
and the market will take of itself.

The proactive investors did well during the first part of the year.
They invested in cash, short positions, and commodities which were
considered a store of value. They did well on both a relative and
absolute basis while the buy and hold investors were down anywhere
from 10-30 percent on the year depending up what they had bought and
were holding.

But all that has changed during the month of October. The energy,
commodity, and agriculture related companies that had soared during
the first nine months of the year have come crashing down hard in the
last few weeks. Oil has gone from $147 a barrel to around $60. Gold,
metals, and agricultural commodities have been in free fall across the
board. The other smart folks who had been cautious have mainly become
more aggressive during the last two weeks and have now lost almost as
much as those of us who have been more fully invested all year long.
Warren Buffett is down about 30 percent for the year while some of
the most successful and legendary hedge fund managers have blown up

High quality corporate and municipal bonds have been hammered as well
as investors have flocked exclusively to U.S. Government-guaranteed
short term debt which is literally yielding next to nothing. The
yields on short term treasuries are well under 1 percent across the
board while intermediate term AAA-rated municipal bonds are providing
after-tax returns of more than 9 percent.

Some stocks are now trading at very low multiples of seemingly
reliable earnings and many high quality companies are paying yields
well above 5 percent. None of it seems to make any sense and in spite
of it all stocks here and around the world keep dropping.

So what's going on here and what should a reasonable person do?

As always, people should always keep cash they know or suspect they
will need in the near future out of harm's way. That is true no
matter what the prospects for the stock market might be.

Beyond that it is important that people understand that much of the
selling is coming from hedge funds and mutual funds that are facing
severe liquidations, margin calls, and in some cases are going out of
business. As was the case with the banks and insurance companies, the
amount of leverage in the hedge fund system has been underestimated
and the selling has persisted far beyond what was expected. That is
in part because hedge funds are unregulated and don't have to report
their holdings so no one really knows how much they have to sell
before they're done. Suffice it to say that it has proven to be a lot
more than anyone thought was possible.

It is telling that on most down days in the market, the selling
intensity has picked up dramatically in the afternoon as fund trading
desks get the word from the front office how much cash they need to
raise by the close. In the case of margin calls, stocks and other
holdings are simply sold out from under them at whatever price they
can get. As hedge funds go out of business and frightened investors
decide to bail out of the market in their 401-K's and mutual funds,
the need to raise cash has been widespread and non-negotiable. Hedge
funds were the biggest investors in hard assets and foreign markets as
well so it is not surprising that those asset classes have been hit
the hardest but they're clearly selling other more marketable assets,
including U.S. stocks, as well.

I have linked you to Warren Buffett's article in the New York Times
and some recent reports by Riverfront Investment Group that suggest
that these aberrations have created outstanding opportunities to pick
up quality assets at very low prices. They also make the case that
while there is no way of telling where the bottom is, we are in a
period of enormous potential for long term returns due to the market

For those of us who have been strapped in and ready for the ride
upward to begin for a while, it means that it just makes sense to gut
it out and wait for some sense of normalcy to return to the markets.
We expect that to happen sooner rather than later. When I woke up at
3 a.m. today the markets were melting down overseas and it was
expected that the Dow Jones Average would open down 1,000 points here.
As we approach the close of trading today, the markets are down but
by "just" a couple percent. Maybe that's a positive sign.

There are those who believe that the financial world as we know it is
coming to an end and the is the beginning of the end of days. Those
people could be right. Even if they're wrong, there is little doubt
that we are in for a prolonged stretch of economic contraction for a
variety of reasons that are now pretty well known.

But it continues to be my belief that a long deep recession is
reflected in today's stock prices and better times lie ahead for those
who can afford to be patient.

Here are the links I referred to:

No comments: