Thursday, January 15, 2009

The Stock Market--Where Do We Go From Here?

Well I guess it was too good to last.

After being up for 2009 for four days (including a long weekend), the continued bad economic news has dragged my accounts down for the year. We are still doing better than the overall market which apparently didn't get the news that this year was supposed to be much better than the horror show we just finished.

I have enclosed the highlights of a letter I sent to all my clients giving my thoughts on the stock market and outlining our strategy at this time. But there is a point that I want to emphasize right up front because it is REALLY important:

There may be industries and individual companies that the government will determine are "too big to fail." But that doesn't mean that the value of their stock can't fall to zero and that their shareholders won't lose all their money.

Last year, the bluest of blue chip names such as Lehman Brothers, Bear Stearns, Merrill Lynch, AIG, Fannie Mae, Freddie Mac, Wachovia, and Morgan Stanley all either went broke or were rescued by being acquired or receiving a government bailout. Most of their businesses survived in some form under new leadership and others like Lehman disappeared. But in every case, their stock holders lost almost everything.

This week, Nortel filed for Chapter 11 protection. Nortel is the massive Canadian version of A.T. & T. that used to be called Northern Telecom. Ten years ago, its stock traded well above $60 a share and its market value was so high that it made up more than one-third of the market cap of the entire Canadian stock market.

Today it is worthless. Like Nortel, Citigroup, General Motors, Chrysler, and many other huge companies have important businesses that will survive in some form. But their shareholders will probably get nothing because the companies are losing tens of millions of dollars a day and they owe their creditors much more money than they have assets to back that debt.

Millions of Americans are losing their homes to foreclosure everyday. In almost every case, it's not because there is anything wrong with the home. It's because they paid too much money to buy it and now they can't or don't want to pay off that debt. It's the same for companies.

So PLEASE don't fall into the trap of thinking that every well-known stock that is selling at a fraction of where it was in the past is a great bargain. The economy stinks right now and it's going to get worse before it gets better.

As I've said before, it's not time to be bullish and it's not time to be bearish--it's time to be smart. There are huge traps and great opportunities presenting themselves in great numbers. The key is to know the difference.

There is very little that can be said about 2008 that hasn't been said before. It seemed pretty clear throughout the year that the economy would be weakening due to fallout from the subprime mortgage crisis.

As we moved into the fourth quarter, the financial problems that had been confined to the housing sector spread to a point where it jeopardized the very existence of the world banking and investment system. The financial crisis took a great toll on investor confidence and the stock market, and the damage was exacerbated by forced liquidations from mutual funds and unregulated hedge funds that had taken on huge leverage to buy a broad range of stocks and commodities.

As those liquidations continued, the economic news worsened and investor fear spiked to panic levels. As a result, we experienced a "perfect storm" during which every class of asset other than U.S. government bonds ended the year with huge losses. Real estate, energy, commodities, stocks, international markets, corporate bonds, and municipal bonds were all down substantially for the year.

The U.S. stock market was down almost 40 percent for the year and most international markets did even worse. There was truly no asset class anywhere in the world that provided a positive return. A number of bond funds managed by prestigious managers were down more than 30 percent in the 4th quarter alone. One Oppenheimer high-yield fund was down more than 70 percent during those three months.

Fear has reached a point where investors are literally willing to accept zero return on their money in short-term government guaranteed notes and CDs. There is now a record $10 trillion invested in cash equivalents that is earning next to nothing. That's how scared people have become. That represents 40 percent of the total value of the stock market—an unprecedented level of caution.

Historically, investor sentiment is a contrary indicator. People tend to be most confident at market tops and most fearful when the news is bad and fear is running rampant. That positive indicator has to be balanced against the bad economic news which seems to be getting worse. More than 2.5 million net jobs were lost in 2008, and the economic downturn and de-leveraging of America will result in lower incomes and spending levels by companies and consumers for some time to come.

So, is there a light at the end of the tunnel or is it really a train coming the other way?

This is a time a great risk and even greater opportunity.

We are avoiding highly-leveraged companies that need to raise massive amounts of capital to stay alive. We are also avoiding companies that are dependant upon a strong economy where consumers have a lot of disposable income and are optimistic about the future. The recession has taken a huge psychological as well as financial toll on most people. Consumers at all income levels either have less money than they used to or feel like they do. As a result, people will put off purchases that they feel are not necessary for as long as they can.

The great opportunities lie in solid companies that are earning good money and are well run, well capitalized, and whose stock prices have suffered as a result of the massive fund liquidations that took place during the fourth quarter of last year. We are particularly attracted to those that are paying good dividends and are likely to continue to increase those payouts going forward.

We want to own companies that provide essential products or services. No matter how bad things are going, most of us will continue to wash our clothes, brush our teeth, heat our homes, and live our lives.

With cash equivalents yielding zero and substantial economic risks remaining, we want to own stocks and bonds that will pay us well while we are waiting for growth. This is the first time in a generation that stocks (the S&P 500 index taken as a whole) are yielding far more than long-term government bonds. In addition, there are a number of gas pipelines, preferred stocks, and corporate and municipal bonds that are providing very attractive returns on a risk-adjusted basis.

Our government is already more than $10 trillion in debt, and we are on track to more than double that number over the next few years. At some point, our creditors are going to demand much higher rates if they are going to keep lending us money. We believe that those who invest in long-term government bonds yielding 2 percent are taking a huge risk. We are increasing our exposure to gold, energy, and hard assets to offset the substantial risk of inflation going forward.

During the final months of 2008, the market's biggest problem was the enormous level of forced liquidations by hedge and mutual funds. That selling is pretty much over.

The problem now is a lack of motivated buyers. There is huge liquidity on the sidelines but investors are sitting on it believing that there is no rush to get into anything right now.

The market will get better when people feel a sense of urgency and get worried that the train is leaving the station without them. Right now they're sitting in the station restaurant sipping cocktails in the belief that the train isn't leaving any time soon. Hopefully they will be proven wrong.


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