Thursday, March 26, 2009

Back To The Future

Over the last several months I have been repeatedly asked by friends and clients when the economy,the stock market, and life in general will get back to normal.

I tell them that we are getting back to normal every day. The challenge is that none of us knows exactly what the new normal will look like. One thing is for sure--it will bear little resemblance to the life that many of us have become used to over the last 20 years.

I vaguely remember what normal looked like 40 or 50 years ago. You worked until you either died or had enough money saved up to support yourself and your family for the rest of your life. If you worked for a company long enough, you got a fixed pension along with your social security when you retired and that, along with your savings, was pretty much it.

The assumption was that you would spend your savings down and you hoped you would have enough to maintain a lifestyle that was not too much worse than when you were actually working and earning money.

When you bought a house, you planned to live in it for a very long time. You put 25 to 40 percent down and paid off the mortgage as fast as you could. If you were lucky, you were able to sell it for about what you paid for it. After all, it was new when you bought it and you had worn it out over all those years. People didn't have huge debts because no one would lend you enough money to get into trouble and what would you spend all that money on anyway?

That is not the scenario that most people have in mind when they ask when things will get back to normal. Most of them are talking about the expectations we developed during the last 20 years which seem less and less normal by the minute.

In recent years, millions of people worked until they had enough money to retire. That often occurred during their fifties and occasionally even sooner. They would then get a second home in a warm place that was generally much more expensive and larger than the home they had raised their families in for years. They could afford it because their first homes had skyrocketed in value during the 80's and 90's.

They would travel, visit and entertain friends and family, eat out often, ski, cruise and play golf, and buy more expensive stuff than they did when they were working. And in spite of it all, their net worth kept going up and up anyway since the value of their homes and investments were rising faster than they could spend the money. Keep in mind, I'm not talking about the super-rich who have always lived this way. I'm talking about millions of "normal" people.

Between 1981 and 2001, the Dow Jones Average went from 800 to 14,000--an increase of more than 1500 percent in 20 years. Millions of people benefited since they--not their employers--now directly controlled the investment of their 401-K, profit sharing, and retirement plans.

Real estate values skyrocketed. In the Sunbelt states, average people could buy land, homes, and condos with very low down payments and flip them for a huge profit after a year or two and sometimes even sooner.

During the tech bubble in the stock market 10 years ago, I remember telling a client that "we live in a time where no level of irresponsibility is going unrewarded." To a great extent that line describes what we came to view as "normal" over the last 20 years.

When the stock market stopped going up eight years ago, people were able to keep spending more and more using home equity loans and a seemingly unlimited supply of credit cards to make up the difference. They built up mountains of debt, but it seemed responsible because their assets, on paper, kept increasing in value.

Until they didn't.

So here we are. Now millions of normal people are deep in debt and/or have no more piggy banks to shake or equity in their homes or investment accounts to draw on. The credit card companies have suddenly pulled in the reins as well.

It is easy and popular to blame the villains of Wall Street and Washington for the mess we're in and they certainly played a large role in creating and deepening the current economic mess. But deep down, most of us know that the dramatic changes in our own behavior and expectations were a huge factor as well.

The good news is even though the economy hasn't bottomed it appears that the stock market has stabilized and the credit markets have started to thaw. We are getting back to normal.

And although it may not be as much fun as the more recent version, the new normal will probably (and hopefully) look more like the normal of my youth than the unsustainable glory days of the last 20 years. We now realize that while that might have been enjoyable--it was never normal.

Saturday, March 21, 2009

We Are So Angry That We've Lost Our Minds

I remember reading news about the race riots in Detroit and Los Angeles when I was growing up during the '60s. It was confusing to me at the time because I could never understand why enraged mobs would vent their anger by killing people and destroying businesses and homes in their own neighborhoods. I could understand the rage, but the actions it prompted seemed totally counter-productive.

Now, more than 40 years later, self-destructive mob rule has come to Capitol Hill. The same members of Congress who were either complicit or clueless while our financial system self-destructed are now so angry over the outrageous bonuses granted to a handful of AIG employees that they have passed legislation that threatens the underpinnings of our whole system.

More than anything else, what has made America unique and great over the years is that we are ruled by laws and not by men or women. If the laws need to be changed then we change them but we never take a Mulligan. We never go back and change the rules retroactively or in the middle of the game because we are angry. Until now.

Last week, in its first bipartisan vote of the year, Republicans and Democrats in Congress were so angry at bonuses that were paid to a few managers at AIG that they overwhelmingly passed a bill that would retroactively punish thousands of employees of several other financial services companies.

A government bond trader or research analyst at Goldman Sachs or Morgan Stanley who was told six months ago that he or she would get a bonus (which on Wall Street is really part of their annual salary structure and not something special) and received the check three months ago may now have to give much of that money to Uncle Sam.

The legislation passed by the House calls for all income over $250,000 earned by any employee of any of the top investment firms to be taxed retroactively at a rate of more than 100 percent (counting Social Security and Medicare). That is not just for bonuses earned at AIG--which is 80 percent owned by the government--but at all firms that took TARP money.

Some of these firms have behaved recklessly in recent years and many executives have become rich by exploiting the system. Anyone who broke the law should be pursued aggressively and pay a heavy price for their transgressions.

But outrage, even justifiable outrage, is no excuse for vengeful, destructive legislation which would have a chilling effect on our economy going forward. What business executive in his or her right mind would commit capital to a venture if they thought the rules of the game might changed by the government after the contract was signed?

Halliburton and defense contractors have admitted that they defrauded and overcharged the U.S. government in the past. Should Congress pass a law today taking back bonuses paid to all employees of those companies years after the fact? That the kind of logic they're using to justify the more than 100 percent tax on Wall Street bonuses they just passed.

Fortunately it seems that some sanity is working its way through the anger and outrage in the Senate and White House. It now appears likely that the bill that sailed through the House with huge support will come under closer scrutiny in the Senate and cooler heads will prevail.

President Obama says we should stay angry but express our outrage in productive ways. I say we should get rid of the anger altogether. We don't have the time or energy to waste on villains--even if they deserve to be punished. That's the job of the legal system--not our legislators. We need to focus on results--not revenge.

Thursday, March 12, 2009

March Madness or The Big Dance?

I knew the stock market would rally this week because my foolproof signal of a market bottom was flashing like crazy. During my 30 years as a financial advisor every time time I have received multiple urgent calls from clients who want to go 100 percent to cash until things "settle down," it came at a time when the market had already been crushed and was about to bottom. I received five such calls and emails in a single day last week and the market has gone straight up ever since.

After plunging by more than 25 percent during the first 10 weeks of the year, a number of market watchers felt we were due for a rally. There is great disagreement, however, regarding whether this rally is just another head fake destined to break our hearts again as stocks plunge to new depths, or whether we have, in fact, put in a bottom from which prices will improve going forward.

Is this just more March Madness or have we arrived at the Big Dance?

As my clients and readers know, I have been saying for months that it is not time to be bearish nor is it time to be bullish--it has been and still is time to be smart. That may sound a little obvious, but it isn't always true.

The end of last year, for example, was time to be bearish. It didn't matter what you bought or how much or little sense it made--everybody lost a lot of money in everything. Stocks, bonds, oil gold, real estate--you name it. There was no place to hide. Nothing worked except cash. Period.

This year, although the broad market averages have continued to plummet, it has been a very different story. The financial services, retailing, and consumer sectors have been a horrible place to be. Even with their recent rallies, Citigroup, J.P. Morgan, and Bank of America are down between 30 and 70 percent in price this quarter. In addition, any company reporting disappointing earnings or announcing the need to raise capital in this environment has been hit hard as well.

But unlike during the fourth quarter, many companies and sectors have provided real opportunities for gains in recent weeks. There have been two major successful themes.

Companies that have introduced exciting new products or provide services that enhance productivity have done well. Apple, IBM, and Google are all up nicely for the year. Akamai Technology, which makes products that enable and support streaming video, is up more than 20 percent., which has introduced the second version of its hugely popular Kindle book reader, is up more than 30 percent in price. These stocks were all down a lot during the final four months of 2008.

Second, most companies or asset classes that deal in hard assets and commodities have also done well. Freeport McMoran Copper and Gold is up almost 50 percent. Petrobras, the Brazilian oil company, is up by more than 20 percent. I continue to recommend a strong overweight in "stuff" since I believe paper currencies around the world will lose their buying power as countries print more and more currency that is backed by nothing to stimulate their economies..

A related investment that has done very well, the ETF that goes up and down in price along with the yield on long term U.S. Treasury bonds, is ahead by more than 25 percent this quarter as the yield on the 10-year treasury note has gone from 2.00 to 3.00 percent over the last 10 weeks. If rates continue to climb as I believe they will, then that investment should continue to do very well.

That's what I've been recommending over the last few months. But what about now? Are all our banks worth zero? Is the economy ever going to get better? Is that is short term bounce in the market or the beginning of the end of the worst bear market in 80 years? Will (as many of my friends now believe) the last one out get nothing?

Although the economy is terrible and getting worse, I continue to believe that this is a time of great opportunity as well as of great risk. That sounds like a cop out, but it's really not.

Take the banks for example. We now all know that many banks are in serious trouble due to the huge losses they are facing from bad loans and bad bets they made over the last several years. Many have already failed and others may have lost so much money during the last few years that they will not be able to survive.

On the other hand, it is hard to imagine a better operating environment for banks than the one we now have. They can take in deposits from the Federal Reserve and depositors at zero cost and turn around and lend money out to borrowers at rates of 6 percent and more. Their "spreads" (profit margins) are huge.

Citibank recently announced that it is showing its best operating profit in years. Its stock is trading at less than $2 because it may be too little too late. Citi may have so many unrealized losses that nothing can save it. But not all banks are in the same hole.

What about those banks that did not become hugely involved in sub-prime mortgage lending and did not invest on the wrong side of derivatives and credit default swaps? They may be in a position to mint money in this environment. It is interesting that the stock prices of Goldman Sachs and Morgan Stanley are up more than 100 percent since last November while most other financials have dropped sharply. Maybe the market is telling us that it makes a difference which financials you own. That not all companies are created equal.

Add to that the fact that many key government leaders are now calling for a relaxation of the mark-to market accounting rules and may reinstate the uptick rule that would keep short-sellers of stock from pounding prices relentlessly. Many hedge fund and ordinary investors are short the bank stocks and the whole market out the wazoo through short and ultra short ETFs. If they decide that the bear party is over and they need to cover, this could turn out to be a rally with some legs.

The stock market is like a dance floor. When everybody is out there doing the jitterbug, there is little upside because the dance floor is full and there's no one left to cut in. Conversely, once most people have left the floor they lose the ability to empty it further--they're already gone. All they can do is fill it up again when they decide to dance some more.

An investor who has sold all his or her stocks and moved to cash can't drive the market any lower than they already have. All they can do is move prices up when they decide to get involved again. That has never been easier than it is today since so much money is in self-directed retirement plans where a few clicks on the computer can move someone from all cash to fully invested in stock in five seconds.

These continue to be times of great risk and great opportunity where being smart makes a real difference. That is likely to be the case for a long time.

Thursday, March 5, 2009

He's a Good Man--Just Not a Very Good Wizard

As I try to wade through the mountain of lies and stupidity that I hear coming from politicians and news personalities (I'm through calling them "reporters" until they start acting like adults), I think back--as I often do--to that great philosophical movie, The Wizard of Oz.

The world of politics and punditry has become like the Emerald City with everyone scurrying around in a panic and looking to the Wizard of Obama to save us all from the evil supernatural threats that surround us.

My favorite of many great scenes in the movie comes when Dorothy and fellow travelers realize that the Wizard of Oz is not a super hero at all. With tears streaming from her eyes, she rebukes him saying, "You are a very, very bad man."

The non-wizard promptly replies, "No my dear. I'm a very good man. I'm just a very bad wizard."

I have been haunted by Oz-like flashbacks in recent weeks as I repeatedly hear our financial crisis falsely described and listen to liars and idiots blame President Obama for a variety of insoluble problems that are not his fault.

First and foremost, the insolvency of a number of formerly great companies is the result of their use of huge leverage and the fact that they gambled and lost far more money than they actually had. It happens all the time--just not on this scale.

People and corporate executives chose to borrow enormous amounts of money to buy things and make bets that they thought would make them big profits. Instead those bets went against them so the people and/or companies have lost between 50 and 1,000 percent of their equity (or soon will) and their creditors have lost big as well since the borrowers can't pay them back.

A firm can have a hundred year history and great products but if it borrows more than the combined value of those assets and can't pay the money back, then they are insolvent. That's true even if they are named General Electric, General Motors, AIG, Citigroup, or Merrill Lynch.

To be fair, like the frog that is boiled to death in water that heats up one degree at a time, we lived through a 30 year period where people could retire and live off their income, investment returns, and home equity in grand style and actually watch their net worth go up. In real estate and other areas, no level of irresponsibility went unrewarded. When we suddenly realized the water was boiling, we were already pretty well cooked.

The stock market has recently resumed its death spiral not because Obama or Timothy Geithner are doing a bad job or making bad decisions. It's because people are finally coming to grips with the depth and gravity of the situation. Would we be better off if McCain had won and Phil Gramm was Treasury secretary? You remember him--the guy who said a few months ago that the recession was imaginary and we had become a nation of whiners.

General Motors' auditors just announced that the company may be broke. This must have come as a huge news flash to the pundits who have been arguing for months over to whether the government should bail the company out. Of course, the stock market has been telling us for a long time that GM is already broke and that its shareholders will eventually get zero. While the "experts" have been arguing about the wisdom of a bailout, GM's stock price has collapsed from $40 to $2 a share over the last 18 months.

The same is true regarding the nonsensical debate and thousands of hours of screaming on the cable news shows regarding whether AIG or Citigroup should be further bailed out. The argument of course ignores the fact that AIG has never been bailed out. Similarly, the great outrage over Obama's desire to turn our country socialist which, of course, ignores the fact that most of the money directed to AIG and others came at the request of President Bush as well as the fact that none of the $150 billion allocated to AIG has benefited the shareholders or executives.

AIG stock has gone from 60 dollars to 40 cents over the last year. Tens of thousands of employees including all the previous top managers of the company have lost their jobs. So who is being bailed out at AIG?

It's not about AIG at all. It's about the creditors and 74 million customers of AIG who would lose out if the company became insolvent and couldn't meet its insurance obligations. The reasons why Bush's non-regulators looked the other way while bedrock financial services companies were allowed to become highly leveraged casinos and their managers sucked billions out of the system for their personal use is another conversation for another time.

Today's conversation is about what needs to be done now. Unlike his predecessor, Obama has been brutally honest and straight-forward and told the American people how serious the problem is and how hard it is going to be to get things back on track. He has proposed some ideas but he has also made it clear that he's willing to be flexible and listen to anyone who has something constructive to add.

This has been very off-putting to Rush Limbaugh and the GOP leadership as well as the Democratic leaders in Congress. They are used to ideology-based decision making where people who disagree are demonized. Limbaugh has become proudly unpatriotic, stating clearly and often that he wants Obama to fail, even though that would mean complete disaster for most Americans.

Many on Wall Street, who are largely to blame for the crisis, have had the chutzpah to blame Obama for the recent leg of the market meltdown. They claim he hasn't had a clear enough plan and is projecting too gloomy a forecast. Bush and McCain, of course, were cheery and upbeat and assured Americans that the economy was fundamentally strong for a full eight months after the recession started. We have seen how far false optimism gets us.

The fact of the matter is that the economic downturn and asset value destruction at a time when most people and companies owe tons of money is the harvest of many years of national self-delusion. The idea that the Wizard of Obama can come up with a silver bullet that is going to make everything fine and get rid of the Wicked
Witch of Irresponsible Behavior only happens in fairy tales.

We have the president that most Americans want and the polls show that even as the economy gets worse, Obama's popularity has grown with most Americans. In a democracy, that's as good as it gets. The only ones who blame him for our worsening economic picture are the "experts" in Washington and on the air.

While our politicians and pundits still speak (and often scream) about villains and wizards, most of us realize that the best we can hope for is a very good man who will try to be honest and make smart choices to help get the country back on track. He is not a very good wizard and like all good men he will make mistakes, but he's our best hope to get back to Kansas in one piece.

Sunday, March 1, 2009

Stock Market Update -- Pigeons Coming Home To Roost

In a market like this, it is easy to feel stupid. Everyone I know has lost money and many people have lost all their money. To one degree or another we have all been impacted by a worldwide economic tsunami that has levelled everything in its path.

Everyone has known for months that serious problems exist. In the past, low stock prices have often signalled great opportunity. I mean we have been told for decades that we should "buy low and sell high." Many technicians and market timers were bearish for much of last year but most decided in October that record levels of investor pessimism and capitulation were signs of a bottom. The U.S. stock market is down more that 40 percent from those levels and making new lows.

Even most of those who remain cautious and say it is still too soon to buy have been saying for months that is is also too late to sell. So while they can technically say they were right on the market, most of their customers have lost big money by hanging on to stocks through this death spiral.

Most of the time, people who lose lots of money are traders or speculators who get caught on the wrong side of risky investments. But this bear market has been very different on two counts.

First, among the stocks that are down dramatically are the largest and most respected companies in the world. Many of the bonds that have lost much of their value were AAA-rated. People who thought they were invested conservatively have lost a fortune.

Second, the smartest people and investment professionals I know have lost the most money during the last year. Normally it's the novice investors who get hurt while the "smart" money typically seems to do better. As we have learned from the Madoff fiasco and other scams, the biggest victims this time have been some of the most accomplished and sophisticated investors in the world.

In addition, legendary investor Warren Buffett has suffered his worst year ever, losing well over 50 percent of his own and shareholders' money during the last six months alone. In addition, dozens of the brightest and most successful asset managers in recent years have suffered similar--and even worse--losses since October.

But it was telling that in Buffett's annual letter to his investors he made it clear that he believes that this is a time of great opportunity. He also shares my view (The Next Investment Bubble Has Started to Pop - Feb, 2009) that U.S. Treasury bonds are not a good place for conservative investors right now.

As Buffett put it:

"When the financial history of this decade is written, it will surely speak of the Internet bubble of the late 1990s and the housing bubble of the early 2000s.

But the U.S. Treasury bond bubble of late 2008 may be regarded as almost equally extraordinary. Clinging to cash equivalents or long-term government bonds at present yields is almost certainly a terrible policy if continued for long."

For months now I have been advising clients that it is not time to be bearish or bullish--it is time to be smart.

As a result, we've been invested in exchange traded funds (ETFs) that invest in precious metals and are short U.S. Treasury bonds. Both of those investments are up for the year as are a number of energy and technology companies--solid, well-run businesses with good management, great products, and lots of cash.

On the other hand, the list of investments that are smart in here is getting shorter as it becomes increasingly clear that companies and consumers have started to save more, pay down more debt, and spend much less. In addition, foreign markets which in the past have often been strong when ours are weak are generally in even worse shape than we are.

As you know, we have avoided the financials, the automakers, and other sectors where companies are going to need to raise capital in this very challenging environment. We now have to expand that list to include companies that are most vulnerable to widespread spending cutbacks that will lead to earnings disappointments going forward.

Our accounts are not up for the year, but we are doing better than the market averages. More important, we remain positioned to benefit from the economic developments we expect to play out. People--particularly retirees--should have enough cash set aside to pay their bills for the next couple years plus whatever additional amount they need to sleep at night. The rest should be invested in a smart way.

A whole bunch of past financial policy pigeons are coming home to roost and most of them aren't housebroken. The results have been messy and ugly. This is not about Obama and it is not about the proposed budget or stimulus package. It's about the policies of the past catching up with us.

At the end of the day, I agree with yet another part of Warren Buffett's letter:

"The economy will be in shambles throughout 2009--and, for that matter, probably well beyond. But that conclusion does not tell us whether the stock market will rise or fall.

Though the path has not been smooth, our economic system has worked extraordinarily well over time. It has unleashed human potential as no other system has, and it will continue to do so. America's best days lie ahead."