Friday, May 7, 2010

What In the World is Going On with Stocks?

This week has provided yet another perfect example of why so many people hate the stock market.

For the first four months of the year business conditions have been improving pretty steadily.  Bailed out corporations like General Motors and many banks have retooled and stabilized and paid much of the money back to taxpayers.  When Barack Obama became president, the world faced an imminent and obvious financial crisis.  The U.S. job market was shrinking as more than 150,000 more jobs were being eliminated than were being created every single week for months on end.

Today it was announced that during April, almost 300,000 more jobs were created than were lost.  That's a net gain of more than a million jobs per month from where we were a year ago. Company after company has announced improved profits based on growing sales and reduced overhead. 

The stock market seemed to be right in synch with the improving reality.  After posting large double digit gains last year, most market averages were up nicely for this year just a few days ago.  On Monday of this week, all the major indices rose more than a full percent.  Things seemed on track.  Now just a few days later, in the absence of any apparently earth shaking news and without warning everything has seemingly changed.

On Tuesday, the bottom dropped out of the stock market and just two days later full blown panic set in as the Dow dropped almost 1,000 points in less than an hour before it came back to fall "just" 347 points for the day.  All of the gains that most accounts had built up in 2010 have been erased in just a few days.

The analysts and experts have been clueless.  No one has yet been able to explain the cause of the 1,000 point roller coaster ride.  Most have chosen to blame the overall carnage on computer glitches and news about credit problems in Greece--problems that have been around and in the headlines for months and which on their face just don't seem to be big enough to warrant the rout and panic that have hit the markets with a vengeance.  It appears that the experts don't have a clue what is going on in the stock market so they are grabbing at any news headlines they can find.

On the positive side, the market selloff this week has caused investor sentiment to shift from complacency to outright panic.  The violent swings of the last few days have looked and felt like forced selling from funds and investors just throwing in the towel without regard to price.  This type of capitulation tends to almost always take place at market bottoms--not in the early stages of a protracted bear market. 

It also shows that even though the market has been in solid rally mode for more than a year, most investors have never really trusted the move.  They just have too many bad memories and the news about deficits, unemployment, and foreclosures have just been hard to ignore.

Skepticism and fear are typically bullish signs because it shows that many investors are still afraid of stocks.  The market, like a dance floor, fills up fastest when lots of people are sitting on the sidelines waiting for a song they like.  Once everyone is dancing, the floor can't get any fuller--it can only empty.  But if the dance floor is already pretty empty, the downside is more limited.  That's why high levels of investor fear are viewed as a bullish sign while complacency can be a harbinger of trouble ahead.

Certainly there has been no fundamental shift in the earnings or prospects for most companies during the last few days.  And yet many of those companies have lost 20 percent of their value or more despite the fact that their recent earnings reports and outlook have been quite upbeat.  Either these stocks represent attractive value at these levels or something very bad is about to happen to our economy that we just can't see or feel right now. 

There is always a chance that the economic disruptions in Greece will spread throughout Europe and eventually to our country as well.  There is also legitimate uncertainty and concern about the huge deficits that are being racked up by the U.S. Government and what economic consequences will ensue.  But it seems like a doomsday scenario is already being priced into the markets long before it is clear that the current uncertainty will lead to widespread economic problems.

One other complicating factor may have been the proliferation of "super sized" Exchange Traded Funds (ETFs) that have become increasingly popular with many investors.  ETFs grew in popularity as a way for ordinary investors to participate in specific market sectors, indices, or geographies in a quick and easy way.  But in recent years, the most popular ETFs have been a broad range of "funds on steroids" that provide a way to make leveraged bets with 2 or 3 times the "pop" of  simple vanilla index funds

As a result, individuals now have the ability to make riskier bets using the kind of leverage that used to only be available to larger institutions.  A byproduct of that approach is greater volatility at all times but particularly during buying and selling panics when everyone is trying to get through a small door at the same time.

At the end of the day, it seems prudent to move assets away from those markets which might be less resilient to these disruptions and also away from the overweight positions in basic materials which are vulnerable to the impact of the rising dollar which has been moving up against the currencies of countries that are in even worse shape than we are.

But generally speaking, I remain upbeat on the U.S. stock market in general and technology, pipelines, credit card issuers, and some financials in particular.

There is a risk that the disruptions in Europe and elsewhere will grow into a huge economic problem that will cause people to stop buying new TVs and new I-Pads and will slow down business in general.  There is also a risk that the long-predicted financial calamity will play itself out as the consequences of huge deficits, major unemployment, and widespread foreclosures come home to roost.

But it seems the bigger risk would be to sell good companies at what seem to be low prices only to watch prices rise dramatically when the sense of panic lifts.  I'm just not convinced that the companies that have done so well over the last year and are forecasting more growth are facing a huge setback due to forces that are hard to see clearly on the horizon.

People should never put money they are going to need over the next few years into stocks.  They should also keep as much additional money out of harm's way to enable them to sleep at night during weeks such as this.  But for investors with a long term horizon and a tolerance for some risk and volatility, it seems we remain in a time of great opportunity for growth across a broad range of companies and sectors.

Saturday, May 1, 2010

The Flogging of Goldman Sachs--A Shell Game, A Semantic Problem, or Populist Rage Gone Wild?

Back before law and order came here to Arizona, they used to just take guilty people out and hang them. But, as locals love to point out, eventually justice became more process-oriented. Since then, they have made a commitment to give the criminals a fair trial before they hang them.

The U.S. Senate and the news media showed last week they are still in the Wild West days. Several Goldman Sachs traders and executives were summoned to the Committee on Investigations to be publicly whipped and shamed for whatever it was they supposedly had done wrong. The message was clear. We know these guys are horrible people and need to be publicly berated and hung. The fact that none of them has broken the law is an irrelevant nuisance that shouldn't slow us down.

Perhaps the most telling line of the 11-hour Senate committee ordeal was spoken by Sen. Jon Tester (D-MT) who commented at one point that "it's like we're speaking a different language here." Tester was referring to his belief that the Goldman representatives were being evasive and unresponsive to many of the questions they were asked by committee members.

In fact, the Goldman folks weren't being evasive. They really were speaking a different language. The most dramatic example of that disconnect occurred during the opening question asked by Sen. Susan Collins (R-ME) of the four young mortgage traders who were involved in the Abacus deal targeted by the SEC. "In your role as a financial advisor," Collins asked each of them, "do you believe you should always act in your client's best interest?"

The traders looked confused by what sounded like a pretty simple question. Collins thought that their confusion must have been contrived and part of a strategy to chew up time. But the fact is that none of the four men she confronted with the question was a financial advisor. I know, because I am a financial advisor. I work with unsophisticated successful people who count on me to tell them what to do with their money. That's what an FA does. In any transaction, I only have one client and I always try to look after their best interests.

But these men were traders and market makers. Their clients are all sophisticated institutions that already know what they want to do with their money. Those clients come to Goldman's trading desk seeking good transactions--not advice. The question posed by Collins was a non-sequitor and completely irrelevant to their circumstances.

As a market maker, you arrange a transaction between two or more valued clients--some of whom want to buy and others who want to sell. It is guaranteed that the deal will work out well for one side and badly for the other. As a market maker in custom-designed mortgages, your job is to make sure you are providing a good and fair market--to provide liquidity and markets for otherwise illiquid securities. That's looking after everyone's best interest.

This would be a conversation worth pursuing if the goal of the hearing in the Senate was to shed real light on any aspect of the situation. The fact that virtually no Goldman clients have stepped forward to complain would also be telling, if informing the public about the issues was the real goal of all this. But we all know that this hearing was not about providing clarity or truth.

Committee chairman Carl Levin (D-MI) spent most of the lengthy inquisition repeating his concern and outrage over how wrong it is for an investment firm to package a security for sale to its clients and then make a bet that it will go down in value. But while Levin made it clear many times that Goldman and the people in front of him should be ashamed of themselves, he never suggested that any of them violated any rules or laws.

In fact by continually pointing out that we need a whole bunch of new laws and rules to make sure this kind of thing doesn't happen again, he essentially was admitting that those laws do not exist today. In other words, the people at Goldman didn't break the law because there are no laws against what they did, even if they did what he said.

A number of very smart people seem to share that assessment. During the week, great thinkers known for their objectivity and brilliance came to the same conclusion. First, Bill Clinton came out and said he isn't sure that Goldman did anything illegal. Then reporter Fareed Zakaria went further and said he didn't think Goldman broke any laws. Finally, billionaire Warren Buffett, known on and off Wall Street for his acumen, generosity, and high ethical standards, told his shareholders he was proud to be a Goldman Sachs customer and investor and he fiercely defended the company's ethics and policies.

This set of facts leads to the following question:   Are all these SEC suits and Senate inquisitions and leaked reports of the Justice Department coming down on Goldman supposed to lead to something real?  Or has it all been part of a political shell game designed to get the public to divert its attention from the real issue?

Has this entire Goldman show trial been a distraction to take everyone's eye off the ball while, armed with populist rage, the Obama administration and the Democrats in Congress set about the business of "protecting Main Street" with far more rigorous and game-changing financial regulation than they could have ever pushed through before the Goldman sideshow whipped everyone up?

Obama and the Democrats are either ideologues with tunnel vision who just don't get it or they are savvy political tacticians who have succeeded in getting everyone to keep their eye on Goldman Sachs while the real story is taking place in the financial regulation committees on Capitol Hill.

If Goldman's stock dropped 20 percent last week over concern about the SEC suit and possible criminal prosecution, it is probably a huge over-reaction. If it dropped because draconian new regulations and tax increases on investments are on the way, then it may have been justified.

I have to admit that I can't figure out which it is.

Which is the whole point of a shell game--isn't it?