Tuesday, February 3, 2009

Stock Market Update -- What We Learned In January

I caught a lot of flak last week when I wrote that "Things are Differenter Than They Seem." I heard from my fourth grade English teacher who was mortified (with good reason) but I also was roundly criticized by a number of my friends in the business who accused me of being blind to the harsh and gloomy realities of the worldwide financial disaster and the relentless flow of horrible economic news.

The numbers would seem to be on their side. We are finishing the worst January in the all-time history of Januarys for the stock market averages as most of the major U.S. indices lost yet another 10 percent. That comes on the heels of an absolutely wretched end of 2008 during which every asset in the world lost much of its value. How can any reasonable person be upbeat in this environment?

Here's how. I stand by my statement of last week. Beneath the surface, this month has been very different. Unlike last quarter when forced hedge fund liquidations drove the prices of everything straight of a cliff, there have in fact been some winners during January. The stocks that have done the worst have been banks and financials (which may be worth zero) and those companies that make products that people want but don't need. Retailers, auto makers, hotels, casinos, and such continue to do quite poorly.

But there were companies and sectors that reported good results and saw their stock prices go up. I repeat what I have said many times: It's not time to be bullish and it's not time to be bearish. It's time to be smart.

So what have the markets taught us during the last month? A number of important lessons:

1. Anyone who is thinking of refinancing their home had better do it right now. My daughter was looking into refinancing last week and watched as rates went up three times in two days--from 5.25 percent to almost 6 percent.

A number of markets have suddenly started telling us that interest rates are going higher and the price of gold and other hard assets will continue to rise as people do the math and realize that paper money is not a good asset to own when governments are printing more and more of it with nothing to back it.

If Democrats get their way, our government will spend trillions bailing out banks and others and providing "stimulus" to every nook and cranny of the economy. If Republicans get their way, we will cut our current tax rates (the lowest in our lifetimes) which will stimulate nothing but cut government revenues more and raise the deficits even more. Our economy is not hurting because corporate tax rates are too high. It is in the tank because people are losing their jobs, watching their net worth plummet, and owe too much money. What will lower corporate taxes due to address any of these real problems?

No one is even talking about what damage these misguided plans will do to the value of our currency or the level of interest rates that will be required to get lenders and other countries to provide us with the long-term loans need to pay for all this.

But the markets get it. Gold was up almost $100 an ounce last month and the rates on long term U.S. Treasuries--the next bubble to pop--shot up by 20 percent. With all the talk about bad banks, Wall Street bonuses, and jump-starting the economy, did you hear one word on the news about skyrocketing interest rates or gold prices last month? Of course not. That's what I'm here for.

2. A lot of companies have been reporting disappointing earnings and laying off thousands of people. But there are companies that are reporting really good earnings and pretty positive outlooks.

The markets were down about 10 percent last month but a number of stocks were up. Energy stocks seem to be bottoming and companies like Google, IBM, Research in Motion, and Amazon.com all beat their estimates and saw their stocks go up for the month. Biotech and health care companies with consistent revenues and/or promising new drugs seem to be doing better as well.

In addition, stocks and ETFs that pay you to wait for growth are hanging in quite well. Natural gas pipelines are my favorites (yielding 8-11 percent with growth potential) but there are number of sectors that make a great deal of sense.

3. A lot of people have bailed out of the market entirely--which is a positive since they can only help stock prices when they come back. They can't hurt prices any more since they have nothing left to sell. Many of those who remain have become traders who are addicted to the action, short term swings and leverage.

It is telling that the most heavily traded exchange traded index funds (ETFs)-- which are supposed to be conservative diversified investment tools--are actually the "Ultra" funds which are leveraged and provide double the move of the underlying indexes.

There has also been a lot of interest in stocks like Citigroup and Bank of America which have been going up or down 5-10 percent a day or more. That volatility is a sign that people aren't investing in these companies--they are trading them for short term moves either individually or through leveraged ETFs.

Until a couple of years ago, it was almost impossible for most investors to go short or use leverage in a meaningful way. Today, anyone can go long or short on margin the Ultra long or short fund in any industry or sector and get four times the move of that index in either direction. It's just as easy as buying a stock. Billions of shares of these funds trade daily, so lots of people must be doing it. That play a big role in creating the big daily swings in the market.

The volatility in the whole market remains a little numbing. Before last year, there were 17 days in history that the S & P 500 went up or down by 5 percent or more in one days. During 2008 alone there were 17 days when the market moved that much. That is partly due to economic developments but it is mainly due to the leverage that has seeped into every aspect of our financial system.

We are still in the midst of a massive deleveraging mode. People are buying less and doing less as they adjust their lifestyle to cope with the new reality. The millions of people who have lost jobs are making dramatic adjustments but so are the tens of millions who had gotten used to supplementing their income with home equity loans or stock market profits over the last 20 years.

All of these facts and figures support my view of how to invest for the future. We live in a time of great risk and great opportunity. The risk is that we assume that formerly great companies are bargains because their stocks have fallen a lot. Many of these companies will not survive and if they do their stockholders may be wiped out anyway. I've talked a lot about the banks, but bankrupt companies like Nortel and Circuit City as well as former blue chips like Motorola and Eastman Kodak (whose stocks have joined the "priced less than a Happy Meal" club) fit that description as well.

On the other hand, there are great opportunities in hard assets, funds that short long term U.S. Treasuries, and solid companies that are well run, provide needed or productivity enhancing products, solve real problems, and/or pay good dividends. Inefficient markets always provide the greatest opportunities and the distress of one group of investors can create benefits for others who are smart and patient.


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