Thanks to reader John for submitting the below video clip titled “I want some TARP.”
Now that the only requirement to get on the federal TARP program (Troubled Assets Relief Program) seems to be an extreme high level of debt along with near insolvency, there are bound to be many others asking for free money.
Enjoy!
Random Roger had some interesting thoughts in his recent post titled “Monday Musings:”
This may come off as an unpleasant rant. Between a couple of articles I found over the weekend and watching the Consuelo Mack show on PBS I came away with a very low regard for the way some folks do things.
First up was an article from Morningstar about what they got wrong in 2008. I have been writing about how worthless the analysis is for as long as I have been writing. They are a bottom up shop and from what I can tell it is a rare day when bottoms up warns of a bear market. Low PEs and other ratios don’t matter when the market is going to rollover into a bear. When the market is going up most stocks go up so a good bottoms up might find stocks that go up more than market but being right about the market would seem to be more important. So with that backdrop Morningstar says the learned a bunch of things in 2008. I would wonder what they learned in 2001 and why that seemingly did not help in 2008.
I have mentioned before that Morningstar’s ratings are one of the most useless tools in an investor’s arsenal yet millions follow them blindly. Whatever approach they use to determine the rankings does not really matter, what matters is that it simply represents a different twist of the buy and hold mentality, which will subject its followers again and again to bear market disasters. Yes, I agree, Morningstar has not learned a thing since the last bear market in 2001, which caused their followers huge portfolios haircuts in 2008.
This article from Seeking Alpha contributor Marc Gerstein posits that collectively the crew at Morningstar is just too young. He believes that experience matters a lot when it comes to navigating the market. I find his take interesting because at 42 I am probably in between his definition of too young and experienced. One reader commented that Morningstar has a bullish bias which hurts them. I don’t know if that is true or not but there might be something to the youth angle but I do think it is bigger than that. Look at Larry Kudlow who must be close to 60 either way or Art Laffer or even Brian Westbury (I think Brian is older than me) they are all experienced and all missed this coming in hideous fashion, bizarre really.
No, age has nothing to do with it; it’s the insistence on using a bullish stance in a bearish environment come hell or high water that is the problem.
This gets me to the Connie Mack show which this week featured Brian Rogers from T Rowe Price and Chris Davis from the Davis funds. Brian’s fund the T Rowe Price Equity Income Fund lost 35.8% in 2008 which was the worst year for the fund going back to 1985 “by a lot.” He said that when there is a severe credit contraction there are very few places to hide. Even safe areas like utilities were “traumatic.” Consuelo asked if there was anything he would have done differently or could have done differently and he answered “no I don’t think there is.” He said they would continue to focus on good quality companies that have struggled, with good balance sheets and valuations. He then said there are things he would have done differently but he didn’t say what.
So I guess the next time the market drops 38% his fund will be pretty close either way? Did he really not know that credit contractions cause problems in the markets? That is the entire idea behind the inverted yield curve.
In past posts I have mentioned that mutual fund managers are not the asset allocators. It is reasonable for a fund manager to invest all of the money in his fund so this post is a bit of a contradiction but I was dismayed by Rogers’ comments and to a lesser extent Davis’. So an active fund manager might be all in but these funds can invest at the sector level in any manner they want so they could have underweighted or avoided financial stocks (financials clearly hurt Davis, not sure about Rogers but JPM, GE and WFC show up in his top ten).
In a bear market there a few places to hide. Since the brokerage industry as a whole has itself dedicated to always being invested in something (so product can be sold continuously) under various disguises of asset allocation, bottom up or top down investing and MPT (Modern Portfolio Theory), they have to pay to price when the bear strikes. All of these themes never look at trends and major market turning points to assess whether ones ideas are still valid.
I am so critical here because I think well if I saw something bad coming (but did not correctly guess the magnitude) how did these guys miss it so badly? They both are smarter than I am and that is not false modesty. Davis might say something about the capital gains embedded in the positions (a point made on past episodes of the show) so maybe no one should buy the fund going forward but that would also mean he made taxes the priority which will lead to tears more often then not. Taxes should never be the first priority.
2008 was not a matter of “seeing something bad coming,” because it assumes that you have the special gift of foresight. It was simply a matter of following major trends in the market place and acting at the turning points.
That’s it; no more no less—no smarts required.
What was required was the realization and experience (from previous bear markets) that senseless holding of any investment, no matter what the economic circumstances or the Morningstar rankings, will have negative consequences when the trends turn south.
A bear market takes no prisoners and even the stock prices of the most bluest of all companies will go down—no exceptions. When the trends change, you simply act and get out. When we went to all cash on October 13, 2000, we had no idea about the magnitude of the following bear market nor did we last year when we exited on June 23, 2008. Trying to assess fundamental reasons when trends head south is simply an exercise in futility.
MarketWatch reports “Much more pain to come, says fund manager.” Let’s look at some highlights:
Investors hoping to see an economic improvement in 2009 may be in for a rude awakening if one fund manager is to be believed.
Jeremy Grantham, chairman at value shop GMO, said that he thinks there will be far more write-downs than is currently assumed, and that to reach the necessary debt levels the U.S. will suffer some serious pain.
“To be successful, we really need to halve the level of private debt as a fraction of the underlying asset values,” said Grantham. “This implies that by hook or by crook, somewhere between $10 trillion and $15 trillion of debt will have to disappear.”
Grantham calculated his figure by assuming write-downs of 50% in equities, 35% in housing, and 35% to 40% in commercial real estate, amounting to a loss of about $20 trillion of perceived wealth from a peak of about $50 trillion. He then estimates private debt — corporate and individual — to be about 50% of that peak level. In straitened times, he said, debt will be lent at closer to a 40% level, meaning that today’s $30 trillion in wealth will lead to ideal private debt levels of $12 trillion.
Grantham believes that there are only three ways to bring private debt levels down in relation to reduced asset values: drastically write down debt, inflate the debt to reduce its real value or adopt the Japanese model of long-term saving.
“Each of the three realistic possibilities…would be extremely painful, each is loaded with uncertainties and even the quickest of them would take years,” said Grantham.
…
Despite his feelings about the broader economy, Grantham sees value in the markets. He recommends investors “slowly and carefully” invest cash into stocks, with a preference for high-quality U.S. blue chips and emerging markets stocks.
“But be prepared for a decline to new lows this year or next, for that would be the most likely historical pattern, as markets love to overcorrect on the downside after major bubbles,” he warned. “Six hundred or below on the S&P; 500 would be a more typical low than the 750 we reached for one day.” Value in the markets? Here’s that nebulous phrase again that can cost you a lot of money. Value translates to something that is subjectively considered cheap. Cheaper than what? Last year’s price? Who cares if it’s cheap; it can get a lot cheaper.
[Emphasis added]
The best definition of value I have heard is by Al Thomas who said “that a mutual fund/ETF only has value if it goes up after I buy it.”
Grantham’s forecast of the S&P; 500 dropping into the 600 range is now the 4th or so prediction I have heard for this number to be reached. That would represent a 25% drop from current prices. Whether we get there or not is not as important as is the question whether the Buy-and-Hold folks are prepared to deal with another major set back.
This market environment can humble anyone at anytime if you’re not prepared to work with an exit strategy that may produce a small loss but will prevent your portfolio from suffering a serious meltdown.
The emails from investors, who have held on to their long positions during this bear market, keep coming in. Here’s what reader Dave had to say:
I am 73 and still working. Against all advice, I remained 80% in stocks because I felt I had such a long way to go to be able to afford to retire, and was willing to risk it, since things were going so well.
Now I have lost over 1/3 of my 401k and personal nest egg. With each new rise in the market, I am encouraged to ride it out. With each dip, I think maybe I should put everything into a money market fund and wait it out. But the thought of making my paper losses permanent when, who knows, Obama and his crew may be able to get the economy on track, has me totally immobilized.
I would appreciate having your view of my situation.
Dave’s story pretty much reflects the view of many who have written in on this topic. I have talked about this before, but it’s worth repeating.
First, be aware that there is no perfect solution to get you out of this mess, but strictly hoping and relying on Obama to come up with some magic trick to not only get the market back on track, but do so quickly, is something I would not want to rely on.
Maybe he will, maybe he won’t, but in the meantime you can implement one idea that might calm you down emotionally and prepare you do better deal with the continued volatility and false rallies:
Sell 50% of your invested holdings and put a 5% sell stop under the balance.
This simple idea will limit further losses, should the market head south again (and there’s a good chance of that) or, if a major trend resumes, you will participate with 50% of your positions. As I said, it’s not a perfect plan, but it’s better than no plan at all.
Look at the worst scenario. If the November lows get taken out, and the S&P; 500 heads towards 600, as some forecasters think, you’ll be glad to have sidestepped further severe losses.
If, on the other hand, a new bull market materializes, you will already be on board with half of your assets and can easily re-invest the other half, once our Trend Tracking Index (TTI) signals a new Buy.
If you think about this, you will realize that most of your discomfort comes from the fact that you are like a rudderless ship drifting in the ocean. Adopting a plan, such as I suggest, may provide you with the life raft you’ve been looking for.
During the market meltdown of 2008, many stories surfaced of publicly traded companies complaining about short sellers contributing to the sharp decline of their stock price.
For the most part this was pure nonsense, but made for a nice excuse, as the fault of a sliding stock price was caused by poor management decisions or simply a failed business model.
Reader Paul submitted the following story about Porsche’s short-squeeze play, which caused sophisticated investors and hedge funds not only headaches but a lot of losses. “How Porsche hacked the financial system and made a fortune” is an interesting tale of how one company survived take-over attempts and shafted the big boys in the process:
In 1931, Austro-Hungarian engineer Ferdinand Porsche started a German company in his own name. It offered car design consulting services, and was not a car manufacturer itself until it produced the Type 64 in 1939. But things got interesting for Porsche long before then.
In 1933, he was approached by none other than Adolf Hitler, who commissioned a car designed for the German masses. Porsche accepted, and the result was the iconic Beetle, manufactured under the Volkswagen (lit. “people’s car”) brand. Today, Porsche’s company is one of the world’s premier luxury car brands, while Volkswagen (VW) is itself the world’s third-largest auto maker after General Motors and Toyota.
Three years ago, Volkswagen found itself fearing a foreign takeover. Porsche, the company, decided to step in and start buying VW stock ostensibly to protect the landmark brand, widely fueling market expectations that it would eventually buy Volkswagen outright. Of course, this isn’t quite what came to pass.
For three years, Porsche kept accumulating VW stock without telling anyone how much it owned. Every time it purchased more, the amount of free-floating VW stock would decrease, driving the stock price up slightly; your basic supply and demand at work. Eventually the share price became high enough that, to outside observers, it wouldn’t have made any sense for Porsche to buy Volkswagen. It would simply have cost too much.
To explain what happened next, I’m going to first tell you about a financial maneuver called shorting.
At any given point, only a certain amount of a publicly traded company’s stock is floating freely in the market. The rest is held in various portfolios, funds, and investment vehicles. Now, everyone’s familiar with the basic idea behind the stock market: you buy stock when it costs little, and you sell it when it costs a lot, profiting on the difference.
But that assumes a company’s value is going to increase. What if, instead of betting a company will go up, you want to make money betting the company will go down? You can — by selling stock you don’t own.
Say you borrow a certain amount of stock from someone who already owns it. You pay a fixed fee for borrowing the stock, and you sign a contract saying you will return exactly the same amount of stock you took after some amount of time. So, you might borrow a thousand shares of Apple stock from me (I don’t actually own any, but play along), pay me $100 for the privilege, and sign an obligation to return my stock in 3 months. At the time, Apple stock is worth $10 per share.
After you borrow the stock, you immediately sell it. At $10 a share, you get $10,000. Two and a half months later, another rumor about Steve Jobs’ health sends AAPL crashing to only $6 per share for a few hours, so you buy a thousand shares, costing you $6,000. You give me back those shares. Because you successfully bet the company would go down in value, you earned $4,000 minus the borrowing fee. This is called short-selling or shorting the stock, and the downside is obvious: if your bet was wrong, you would have lost money buying back the shares that you have to return to your lender.
Now things get kinky.
When Volkswagen’s share price exceeded the point where it made sense for Porsche to buy the company, a number of hedge funds realized that Volkswagen shares have nowhere to go but down. With Porsche out of the picture, there was simply no reason for VW to keep going up, and the funds were willing to bet on it. So they shorted huge amounts of VW stock, borrowing it from existing owners and selling it into circulation, waiting for the price drop they considered inevitable.
Porsche anticipated exactly this situation and promptly bought up much of these borrowed VW shares that the funds were selling. Do you see where this is going? Analysts did. According to The Economist, Adam Jonas from Morgan Stanley warned clients not to play “billionaire’s poker” against Porsche. Porsche denied any foul play, saying it wasn’t doing anything unusual.
But then, last October 26th, they stepped forward and bared their portfolio: through a combination of stock and options, they owned 75% of Volkswagen, which is almost all the company’s circulating stock. (The remainder is tied up in funds that cannot easily release it.)
To put it mildly, the numbers scared the living hell out of the hedge funds: if they didn’t immediately buy back the Volkswagen stock they were shorting, there might not be any left to buy later, and it isn’t their stock — they have to return it to someone. If their only option is thus to buy the VW stock from Porsche, then the miracle of supply and demand will hit again, and Porsche can ask for whatever price it wants per VW share — twenty times their value, a hundred times their value — because there’s no other place to buy. They’re the only game in town.
And that, my friends, is called a short squeeze.
Porsche’s ownership disclosure sent the hedge funds on such a flurry of purchases for any Volkswagen stock still in circulation that the VW share price jumped from below €200 to over €1000 at one point on October 28th, making Volkswagen for a brief time the world’s most valuable company by market cap.
On paper, Porsche made between €30-40 billion in the affair. Once all is said and done, the actual profit is closer to some €6-12 billion. To put those numbers in perspective, Porsche’s revenue for the whole year of 2006 was a bit over €7 billion.
Porsche’s move took three years of careful maneuvering. It was darkly brilliant, a wealth transfer ingeniously conceived like few we’ve ever seen. Betting the right way, Porsche roiled the financial markets and took the hedge funds for a fortune.
It’s been exactly 7 months, since our domestic Trend Tracking Index (TTI) signaled a sell on 6/23/08 to move out of domestic equity funds/ETFs and into money market.
Since that day, a lot has happened and, unfortunately, those investors without a clear exit strategy saw a large portion of their portfolios destroyed in record time. Despite vicious rally attempts, most portfolios are still showing steep losses which may take many years of quality investing to make up.
The chart shows an enlarged portion of our Domestic TTI demonstrating the quick and devastating breakdown in the financial markets. Let’s take a look at how this will help us eventually re-enter at much lower prices than we exited.
On 6/23/08, the trend line (red) was crossed to the downside and its value stood at 47.10 (#1). As of yesterday, the trend line had inched down to 43.15 (#2), which is a drop of -8.39%.
At the same time, the TTI price line (green) made its yearly low during the week of 11/17/08 at 36.38 (#3). From that point, the price recovered and has now gained +5.69% to close at 38.45 (#4) as of yesterday.
The bottom line is that as long as prices are continue to hover around the levels of the past 3 months or so, the Trend line will descent faster than the price line will rise. In other words, the longer it takes for the markets to turn around, the lower the trend line will sink before meeting the rising price line and generating a new domestic Buy signal. This will enable us to re-enter closer to a potential bottom, which is what every investor is clamoring to do.
With the benefit of hindsight, we now know that the wild bounces and sharp drops after the November bottom have certainly helped us to avoid several whip-saw signals.
As I have mentioned before, this market environment rewards those with patience and the ability to wait for the right moment to re-deploy investment capital. Try not to focus too much on short-term swings but focus on the big picture along with a plan to be disciplined in your decision making. In this post bubble era, it’s the only way to survive with your portfolio intact.