Saturday, November 29, 2008

From the Wayback Machine

Too much time on my hands over the weekend. I dug around in the archives, both physical and electronic. From a box of old magazines, I came across Newsweek issues from December 2, 1974 (Cover story: "How Bad a Slump?") and January 20, 1975 ("Out of Work"). Some quotes that could have been lifted from today's issues:

"The recession worsens. Layoffs proliferate. Profits fall. Bankruptcies swell... And the worst is yet to come."

"Each day last week brought fresh reports of layoffs--massive ones in the auto industry and lesser ones in plants producing products as varied as textiles, electric organs and bicycles."

and from a New York Times editorial 12/29/1974 (via web archive), about a week after the market had bottomed:

"The year is ending with much of the nation in a state of deep anxiety over the course of the economy. There has been nothing like the present degree of apprehensiveness—or confusion—about the business outlook since 1930. And the question on everybody’s mind is whether years like 1931 and 1932 lie ahead."

By the way, of the many interesting things in boxes in my basement, I was most amused by the AIG 2001 annual report, which proclaimed boldly on the cover "The Greatest Risk Is Not Taking One."

Saturday, November 22, 2008

I interview myself

In this, my first blog post, I thought that I'd start out with an interview. After considering a few other candidates, I decided to interview myself.

YAIO: So what do we do now? Staring in the face of a nasty recession or worse, worldwide markets in shambles, seemingly nowhere to hide?

ME: I get the feeling that we're at an important inflection point now. Sure, there's lots of bad economic stuff ahead, and plenty of people have been blown up trying to call the bottom. I'm not saying that things won't get worse, but for the first time I'm seeing signs that we're at a turning point. We probably aren't at THE bottom, but we're near A bottom.

Just this past week I feel that the market left the path of "nasty bear" and strayed into "irrational". The thing that was most notable to me was the 9 point rally in 30 year treasury bonds on Thursday. NINE Points! I don't know what the previous record was, but I'll bet it was less than Four. Some media reports pointed to that move as an extreme manifestation of flight to safety and fear. I've got news for you: you don't buy 30 year bonds for safety, and in particular you don't buy them up nine points for safety. That was a mechanical move, probably by fixed income investors desperate for duration. It reminded me in some ways of the Volkswagen short-covering explosion last month.

YAIO: So what does that tell equity investors?

ME: We've seen some extreme moves in the markets lately. But it's dangerous to try to fade the extreme moves. Merely the fact that the stock market loses 50% of its value isn't a reason to buy-- it could certainly lose another 50% and then maybe another 50% after that!. Remember the quote attributed to Keynes: "the market can stay irrational longer than you can stay solvent". But in my experience these extreme moves that touch all asset classes often end with some type of blowoff. I think that the treasury move was a blowoff that signals a turning point.

But I'm not saying that a nine point move in the long bond is a sign that the stock market will rally. It's just an ingredient in a mix that gives me a bullish gut feeling. Here's what else is in that mix: First, the stock market's recent move is clearly an extreme. Before yesterday's rally, we were as oversold as we've ever been-- ever. Even if the S&P is going to zero, it won't go straight there. The biggest rallies occur in bear markets. That's the market's way of keeping honest. There are no free lunch, one-way trades.

Second is the zero boundary theory. Like I said, we're not going to zero, but the lower we get, the closer we are to the bottom. I can't tell you what the limit is on the upside: the S&P could go to 1500 or 15,000. P/E could go to 100x or higher. Just ask anyone who shorted tech stocks during that bubble. But I'm a lot more certain about predicting the downside limit. While individual stocks can go to zero, the entire market can't. Despite my comment above, I'm pretty confident that the market will absolutely not go below400-- let's say 500, which is still plenty conservative. That's still another 35% lower than Friday's close, which would be very ugly. But it defines your lower limit and your risk. But the upside, unlike the downside, is theoretically unlimited. I like those odds: 35% downside, unlimited upside.

YAIO: How do you know that the S&P won't go below 500? What are your valuation metrics?

ME: I suppose that's possible. But you can't protect against every single risk, or you'd never ride in an airplane or walk across the street. If a sub-500 S&P would cause you to lose your house or cause your family to starve, you shouldn't be in the equity market. I'm not saying that there's absolutely no chance of the market going to that level or lower, but it seems like a pretty safe bet. And as far as valuation, 500 would be 10x a $50 S&P earnings level. I'm not a big fan of valuation metrics because they seem to be least helpful just when you need them the most. But 10x $50 seems pretty dire.

YAIO: Some have suggested that both bull and bear forecasts will be wrong, and that the market will just flop along around this level for a long time-- possibly years.

ME: That could be. Bob Farrell predicts that we'll trade in a range of Dow 7800-98oo for a while, probably into next summer or so. That sounds about right to me. But from today's level, it gives us a pretty good trading opportunity. I'd be a seller if we neared the upper end of that range any time soon. But that's up over 20% from here.

YAIO: What do you think about the fact that you seem to be in line with the consensus in saying the market is cheap? Don't we need to wait for some type of capitulation?

ME: Frankly, that does bother me a bit. I think that most investment advisors are telling their clients not to sell-- it's too late, and that it's a mistake to puke at the bottom. However, if they're not recommending selling now, it's hard for me to believe that they'll get bearish at lower levels, even if the economy continues to weaken. Also, keep in mind that people running investment advisory businesses have a built-in bias. They've already seen their assets under management (and therefore their fee income) drop by nearly half. If you advise people to go to cash, why do they need an investment advisor? So you stay long, and if the market recovers, your business recovers. If the market continues to go down, the advisor's not worse off than if clients sold everything and went away.

But I am watching the consensus/contrarian thing. I see both bullish and bearish indicators every day. I think that when we ultimately bottom, it won't be because we've reached a point of maximum pessimism on some indicator. Rather, I think that we'll bottom after we go through a period where people just don't care about the equity markets for a while.

YAIO: Sounds like you're saying we're due for a bounce, but you don't have much confidence in the long term. What should we be buying now?

ME: That's about right. It depends on your time horizon. I'd focus on two strategies. First, there's the silly cheap stocks. They're short term trades into the bounce. Pick your own favorites here, but look for companies with fundamental franchise value even if the near term earnings picture is poor. Most of the large cap (or should I say "formerly large cap") banks fit this category. Also some media companies like NYT. I'll think about it and come up with some more names in subsequent posts.

The second strategy is to use this as an opportunity to make long-term investments in great companies at attractive prices. Boeing, Caterpillar, Exxon, Coca-Cola, Pfizer and IBM are a few that come to mind. If you're willing to invest for five years or more, I think that the risk-reward tradeoff for stocks like these is extraordinarily favorable. Take half-sized positions now, and prepare to buy more if they get cheaper (if you've got the stomach for it, consider selling out-of-the-money puts for the other half position, but that's a discussion for another day). The problem with this strategy is that most people don't have the required level of patience and discipline. They watch the value of their account and are likely to get scared out in a market selloff. Some very smart investors counsel to never add to a losing position. It's hard to do, but I think if you've got the right investments and the market gives you an opportunity to buy more at a lower price, you take it.

Finally on the topic of long-term investments, be sure to look for long-term growth opportunities. Although you'll hear plenty of advice to avoid investments in technology companies due to a cyclical downturn, many tech innovations are as anti-cyclical as you can get. Computers and cell phones will always get cheaper and better. The internet is a huge influence in our lives today, but it will only get more important in the future. Pick your own way to play tech, but be sure to have some in your portfolio. For my money, there's not much better than Google, and at yesterday's price of about 250, it's got a great risk/reward profile.

YAIO: Hmmm... you sound like a pretty smart guy. I presume that you've been a successful investor?

ME: honestly, not really. My biggest mistake was to steadily add to my equity portfolios over the past 20 years, and although I did quite well in the early years, that strategy has been a net loser since about 1998. I was brought up on the philosophy that as long as you've got a long-term horizon, stocks are the only place to be. "Long-term equity returns average 10%..." we all assumed that was true. But it's a lot more likely to be true in the near future now that we're back at the 1998 index levels.

that's it for now.