lucyb —  November 21, 2008

If you have whiplash from watching the stock market there is a good reason. According to Chart of the Day, 19% of all trading days over the last three months have been either up or down more than 4%. This is, in fact, the most volatile the stock market has been since the 1929-1932 period. If you think you have never seen anything like this, it is because you haven’t. Additionally, the current correction is the largest since World War II. For many investors, it may be difficult to see the big picture amid the clatter and chatter of this ongoing financial crisis.

The financial crisis that unfolded in the banking and brokerage industries has been mitigated (if not solved) for the time being. Unfortunately, the damage from the sub-prime crisis has spread and we now have a cyclical recession. This is a global recession — Japan and Germany are also experiencing recessions and many countries around the world are also slowing down as the American consumers put the brakes on. Fortunately, this recession is accompanied by low interest rates, low inflation and now lower gas prices. However, this past week presented some new information which we need to digest and to which we must adjust.

First, discount retailer Target Corp. reported Monday that a difficult retail environment and weak results from its credit-card segment led to a 24% decline in third-quarter earnings. Profit for the three months ended Nov. 1 fell to $369 million, or 49 cents per share, from $483 million, or 56 cents per share, last year. That wasn’t so bad, but profit in its credit-card business fell 83% to $35 million from $202 million last year because of Target’s lower investment in the portfolio and a decline in the portfolio’s overall performance due to higher bad-debt expenses and lower interest rates. The higher bad debt means that more customers who rely on credit cards are not paying. This does not bode well for retail as these customers will not be able to get credit in the near future and will buy less. Buying less means fewer jobs at retail and in the industries that support it. It also means more write downs are in the cards for banks in the next few months if they have exposure to credit card debt.

Another problem for the banks is brewing in the commercial real estate area. Recently commercial properties have been marked with the term “price reduced.” That is not good news for the lenders who own those loans on these properties and may also present another round of write downs for the banks and various financial institutions that have made those loans.

Adding fuel to the fire, BASF (think the European equivalent of our Dow Chemical) said that it will temporarily shutter 80 plants around the globe due to “massive” demand decline. About 20,000 workers globally will be without work. You may have seen BASF TV commercials that say, “At BASF we don’t make the things you use, we make the things you use better.” So they are an early indicator of a more general slowdown. Layoffs in manufacturing will circle back and impact retail and unemployment.

Added to this mix is the debacle that is playing out between the auto industry and Washington. The big three want bailout money and so far Washington has said no. No doubt this dance will go on for awhile. We have little doubt that at the end of the day there will be some kind of aid in the form of loans for the automakers. However, we are fairly certain that when the deal is done it will mean a smaller domestic auto industry whose workers at all levels have made pay concessions. This will ripple through the economy and also impact employment and retail.

Meanwhile, a report issued by the Fed this week said that they expect unemployment to hit 7.5% and the recession to last into next year. However, the Fed and treasury department have been guilty of underestimating the extent and scope of the financial problems that began to emerge last summer. Given the aforementioned, it would not surprise us if unemployment hit 10% and the result of that will be a recession the likes of which we haven’t seen for quite awhile.

In the midst of this news one of the stocks we hold, Qlogic Corp., announced a $300 million share repurchase this week. However, the stock went down with the market that day (about 6%) as the market ignored the news. This in spite of the fact that the buyback represents enough money to repurchase 25% of all the outstanding shares! It reflects the fact that investors are shunning equities at this point. However, it also shows the strength of this company and how its shareholders will come out of the bear market owning a bigger share of the company.

Given these events and after careful analysis, we have taken a measured, defensive action. While the stock market accounts for this type of news, the risks may still be underestimated. The million dollar question, to which no one has the answer, is has the marked declined enough to account for the mounting bad news? So, in light of this, we are updating our position of last month (“No Time To Sell”) and raising about 20% cash in our client accounts. We have sold the stocks that have been among the weakest performers. We feel this is warranted at this time. If the market rebounds at once, we still own enough stock to participate in the upside, and if there is more pressure on stocks we will be able to reinvest some funds at lower prices and mitigate some of the additional declines. If events happen that warrant redeploying these funds we will do so as well. These are unprecedented times and navigating the waters is difficult. We will be as prudent and nimble as possible.

What should you do? I urge you to contribute early to your retirement accounts, and to continue to add to your investments while the market is low. You might be scratching your head about that advice, and wondering whether I have lost my mind, but take a look at some numbers and follow my logic that historically speaking, even in prior bear markets, if you put money in even halfway to the bottom and you kept putting it in, you would emerge a winner.

Let’s look at the three years from 1931-1933, a very tough time in our country’s financial history. In 1930, the Dow closed at 164, down 25%. In 1931, it closed at 78; in 1932, it closed at 59; in 1933, it closed at 99. If you had continued to put money into the market during those times, you would have emerged ahead. Here’s how: let’s say you put in $1,000 at the end of 1930, which would have bought you 6.1 shares. At the end of 1931, the next $1,000 you invested would have bought you another 13 shares. At the end of 1932, your next $1,000 would have bought you another 16.6 shares. So, over the first 24 months, you would have bought 35.7 shares. You would have been down about 28% after 24 months. Then, over the next year, your 35.7 shares would be up 20% (not including dividends), so even investing over a 36-month period starting at the end of 1930 and continuing through 1933, you would have had a 20% return on investment, not including dividends, which would have driven that figure even higher. So even in a down market, if you stay with it and add money, you’ll be better off when you come out the other end. In other words, you buy when it’s on sale.

Remember that no matter what happens, you are unlikely to need all your money back all at once, so even if you are down, you can survive this. We won’t minimize our pain by calling it a paper loss, but you most likely won’t need to retrieve all your investment money at once. Make no mistake this has been ugly! While this is incredibly painful to live through, there will be an end to the volatility and craziness that marks almost every day in the market these days. Remember, economic data is always poor at market bottoms and negative sentiment is pervasive as well. However we note that there are some positives — energy prices, interest rates and inflation are low. In addition, corporate insiders have bought shares at an increasing pace with the market decline. For the 7th consecutive week, insider buys exceeded their total sells. They are taking a long-term view, as we think you should.

Overall, we remain hopeful but cautious.