Market Comment Oct 2008

lucyb —  October 8, 2008

I wrote the article below this note about a week and a half ago, which, given the drastic and rapid market decline, feels like about 5 dog years!

Clients have been asking lots of questions — how much longer will this drop be? Should we sell stock? What should we do? I thought the current situation required me to shed some additional light on my actions, or in this case inaction, and what my thinking is. So I thought that I would address tose issues first followed by the article

Market Q & A

Clients have been asking lots of questions — how much longer will this drop be? Should we sell stock? What should we do? I thought the current situation required me to shed some additional light on my actions, or in this case inaction, and what my thinking is.

Q: Why didn’t I exit the market in a meaningful way?

A: As of the end of September, our average growth account was down about 10% vs. a 20% decline for the S&P 500 for the year to date in 2008. This was not surprising as historically we have captured about 65% of the market’s downside and about 110% of the upside.* Therefore, given the difficulty of market timing, there is a disincentive to engage in that activity. This is doubly true for us. Even if we are correct we only gain about half of the benefit and if we are wrong we lose 110% of the gain. Therefore, dodging in and out of the market is a losing bet in general, but even more so for us.

Certainly the month is not over yet and there will no doubt be additional developments, but this has been an atypical month for us. Typically, we are performing with, or better than, the market.

Q: Now what should I do with my various accounts, or more realistically, what do I plan to do with the portfolios I manage for you?

A: I plan to stay the course. The reasons are as follows:

1) Currently only 5.8% of all NYSE (New York Stock Exchange) stocks are trading below their 10-week moving averages. Historically, when this figure dropped to 15% the market was up an average of 9% in 1-3 months.

2) On October 6 the S&P 500 closed at its lowest price-to-book ratio since 1991, also a time of market distress. This makes valuations attractive.

3) Sentiment indicators among investment advisors have just shot up to 53%, a 14-year high, according to Investors Intelligence. This is typical of market bottoms when the supposed professionals start throwing in the towel.

4) The wild trading on Monday saw the largest ever number of new 52-week lows among the S&P 500. According to Schaeffer Research, excellent returns were achieved by investing after high numbers of lows are hit in the S&P stocks.

5) The VIX (volatility index) is through the roof. Past market bottoms have occurred with the VIX at about 38. The VIX spiked up to 58 this week. Extreme volatility is associated with the kind of fear scene at market bottoms.

6) The put call ratio hit 1.38 twice last week. In English, that means investors are buying more puts (bets that the market will go down) than call options. A ratio this wide also indicates fear and uncertainty.

7) Central banks and governments all over the world are engaged and taking action to help straighten out the credit mess. Sooner or later the effect of the liquidity they are injecting into the market, plus lower interest rates, will show up.

8) When the markets were going down during most of the year, a prime culprit was higher oil prices. At one point oil was over $140 a barrel and predictions of $200 a barrel were being made. Today, oil is well below $100 and dropping. The resulting decline in gas prices should help consumer spending.

9) Businesses do not have large inventory buildups. In the pre-computer age, businesses would be stuck with inventories at the beginning of a recession and have to work their way out of those inventories. In today’s age of instant information, manufacturing will pick up as soon as demand picks up and the issues of old inventory and inventory overhang are significantly less than during past times of economic hardship.

10) Insider buying vs. selling is at a very high ratio.

11) Surprise, surprise: The National Association of Realtors reported today that pending home sales rose 7.4% from July to August. It also said its seasonally adjusted index of pending sales rose to 93.4 from an upwardly revised reading of 87 in July. This was the highest reading since June 2007, the month before sub-prime became an expression that we all became familiar with.

Q: But aren’t most of those reasons historical? Does it have to happen that way this time?

A: The answer has a few aspects. First, most of what has been mentioned has to do with the behavior patterns of humans. Psychologists tell us that the best predictor of future behavior is past behavior. Therefore, we are heartened by the indicators. To say the indicators are wrong this time is to take the position that the world is going to enter a “depression.” While that is possible (anything is possible), it would be the first time that a catastrophic event was successfully predicted by a broad part of the population. Not impossible, but not very likely either.

If you would like a supporting perspective on this, please check out the article by Nobel Economics Laureate Gary Becker in the Wall street Journal

Second, the central bankers and governments of the world have learned a great deal from the Great Depression of the 1930s and are working hard to avoid it. My guess is that while the current economic slowdown is clear, at the end of the day, this will not look much different from a garden variety recession.

Our best advice is to stay the course, turn off the business news and do something you enjoy. We all want know if we have seen the bottom. That is unknowable. The more important question is where your portfolio will be in one, three or five years. I think if you stay the course, and especially if you continue to contribute to your accounts, the answer may be as surprising as today’s housing contract number.

This is my best current thinking. There are no guarantees, but I am comfortable with the position. As always, we remain open to new developments. We think the bad news is out and widely known and that most new developments should be more positive than negative.

Please continue to read the original article as it is still very pertinent.

–David R. Fried

Buy, Sell or Run for the Hills?

These are hard times to be in – or stay in – the stock market. Recently the Dow Jones Industrials have had four days with price movements either up or down 300 points. This was followed on September 29 by the single biggest point decline, 778 points on the Dow (though not percentage decline), in stock market history!Since then the volatility has continued.

People are worried about recession and the possibility of a late 1920s-style depression. What they are not seeing is that the Federal Reserve is taking actions now that are opposite to what the Fed did at that time. In the words of my colleague Bill Staton, “By 1932 the Feds had reduced the money supply 25% to fight off what they thought to be inflation even while the global economy was in meltdown from deflation. There were virtually no doomsayers then. Now the airwaves and print media are filled with them. As The Wall Street Journal noted, ‘It’s hard to see how a depression could get under way when so much capital is waiting in the wings. The financial future is no more uncertain now than it used to be.’ ”

It is estimated that there is currently well over $3 trillion in money market or other cash instruments. This money, over four times the size of the proposed federal bailout/rescue package, will be put to use buying bargains in stocks and real estate. When this money rolls into the markets, and at some point it will, things may change in a hurry. Wouldn’t it be great to know ahead of time when that will happen? Unfortunately, we cannot predict when the market will fly and when it will tank.

It’s not just hard to time the market, it’s impossible, so we strongly advise that you don’t attempt it. This simple warning is among the most important rules of investing. It also happens to be among the most important rules broken in investing, because many people think or hope they can do it. Unfortunately, what they usually end up doing is underperforming the market.

Not convinced? Try this simple experiment: Watch one of the financial channels for an hour, and the truth will dawn as you watch one analyst say stocks are rising, while the next predicts a plummet, and a third suggests that first they will rise, then they will fall, but overall the result will be flat line. Our advice is to turn off CNBC and Bloomberg and keep them off!

If you consider some of the information that flies at investors all the time, it should be no surprise that there is confusion in the market. For example, at the end of August the Labor Department said new applications for unemployment insurance rose by 15,000 from the previous week. However, that followed three consecutive weeks of a decline of more than 10,000 applications per week. Another example: One Monday in September a barrel of oil ranged in price from about $100 to $130 in one day, the largest absolute and percentage daily change ever!

And so it goes — the push/pull of competing information rolls on. The market is so complex, comprising so much information from so many different sources and factoring in countless unknown future events that no one can possibly know when it is going up or down. So please resist the urge. The experts even admit they don’t know how to do it, and they advise you not to do it. (More on this later).

Fortunately, there are some telltale signs. Legendary investor Warren Buffett just made a loan of $5 billion dollars to Goldman Sachs and followed with a similar loan to general Electric. In addition to the interest on the loans, he will receive warrants to buy another billion in stock from each company. The warrants will only be valuable if the stock goes up, so Buffett is betting on that scenario. Also, Microsoft, Nike and Hewlett-Packard all recently announced that they would begin to repurchase stock – more than $50 billion between these three companies alone! All together it adds up to some pretty smart money stepping up to buy.

At the same time many people are in a panic. Will the downturn we are currently in last another day, another week, another quarter or another year? Who knows? And how much lower can a 401K go before its owner fears his retirement is melting away? Behavioral finance teaches us that markets will almost always disappoint the majority of investors. Today that majority has run for the hills. They are likely to be disappointed that the market doesn’t go down to the levels they expect and even more disappointed when they discover they have missed out on the next market up leg.

This brings us back to the question of timing the market. On timing:

· Legendary investor Peter Lynch said, “The real key to making money in stocks is not to get scared out of them.”

· Buffett wrote in his Berkshire Hathaway 2004 Chairman’s Letter, “Investors should remember that excitement and expenses are their enemies. And if they insist on trying to time their participation in equities, they should try to be fearful when others are greedy and greedy when others are fearful.”

· Philip Carret, the investor Warren Buffett admires most, said, “If you buy stocks because of what you hope will happen next week, you are trying to be a market timer. I never knew anyone who could time the market consistently, so why even try?”

· Benjamin Graham, Warren Buffett’s mentor and the grandfather of value investing, said, “There is no basis either in logic or in experience for assuming that any typical or average investor can anticipate market movements more successfully than the general public, of which he himself is a part.”

There are scores of analyses that show it’s not a good idea to try to time. People who try it most often wind up selling low and buying high, and they miss out on the surge. Arguments against timing are simple: the market is extremely volatile and impossible to predict. It’s ridiculously easy to miss the best performing days, and, if you do, you will have far worse performance than if you had stayed put the entire time. When the market moves, it often tends to move in quick bursts, so by the time you wake up to the fact an advance has begun, much of it has passed. Miss that first part and you miss out on the bulk of the gains.

Let’s say, for example, that you want to believe you can beat the odds. Even if you think your ability to predict the market’s next move is higher than 50/50, the odds are still not in your favor. You must predict the correct time to sell AND also the correct time to buy again, which means you need to make two concurrent predictions of where prices are heading. Your odds at the machines in Las Vegas seem better than that.

As Buffett says, “Be greedy when people are fearful” and if people aren’t fearful now, then I don’t know what fearful looks like. In 1998 people were greedy when they should have been fearful. It might surprise you to know that since January 1998 the market (as measured by the S&P 500) has gone up less than 2% annually. Remember how enthusiastic everyone was about buying more and more shares of the hottest tech stock? No one would have believed then the market would go almost nowhere for a decade. Likewise, no one believes now that the market can go up from where we are now. I suspect that the crowd is as wrong now as they were then.

Meanwhile, we opened the doors of Fried Asset Management, Inc. in 1998. Since then we have managed client assets in the stock market through the tech wreck, the Asian Contagion, the Russian Ruble crisis, the 2002 recession, September 11th and my favorite, Y2K. Remember when people sold stocks because they thought no one’s computer would work when the clock struck midnight on December 31, 1999?

Somehow we have managed a return of about 11.5% a year since January 1, 1998.* The funny thing is that had I known the market would be so bad over the ensuing decade I would have pursued a different line of work! The housing and credit crises are worse than any of the aforementioned situations. However, this too shall pass. I hope the government will have passed the Treasury bailout plan in some form by the time you read this. (If not then the market will have reacted to that by the time you read this as well.) I believe that will be the beginning of the end of our current crisis.

If you are in the market, you should think twice before selling when major corporations and investors like Warren Buffett are buying. To boot, we are still the most politically stable country in the world and our markets are about 25% off their all-time high. You should think twice more about going with the herd. They are almost always wrong.

lucyb

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