History Lesson & Bear Market Advice

History tends to repeat itself. The economy and the stock market are no different. We have had, and will continue to have, economic expansions followed by recessions. To give you an idea of what to expect, consider the last recession.

It was the result of another bubble bursting (in Silicon Valley, not housing). In 2 1/2 years (early 2000 through late 2002) the S&P 500 fell by 50.5%. Investors felt massive pain and many took dramatic action by getting out of the market. That was the right emotional decision in their minds at the time (because they didn’t want to take any more pain) but it backfired financially.

After a 2 1/2 year bear market, the S&P 500 bottomed in October 2002 and rose by 105.1% over the next 5 years. Those investors who stuck with the market and even added to their investments as prices dropped reaped huge rewards. Those who exited the market out of fear missed out.

With the market down more than 35% in the last year, what should investors do now? For the answer all we need to do is look at history. About 97% of all five year periods have seen the stock market go up, as have nearly 100% of all 10-year periods. If you are a long term investor (5 year time horizon or more by my standards) the numbers imply you should stay in the market.

You may have noticed that Warren Buffett has been very active in the market in recent weeks, investing billions of dollars. Is he crazy? No, he simply knows that when prices drop significantly there are bargains to be had. Future stock price returns are going to be higher during bear markets than bull markets because prices are lower. It isn’t any different from buying a house, a car, or a cart of groceries. When things go on sale, we should buy more of them. Have you ever been to the store, seen your favorite cereal on sale, and bought a couple extra boxes than normal because of the price? I know I have.

Stock investing shouldn’t be any different than grocery buying. It is true that it all sounds so simple, but isn’t because emotions and psychology come into play more with stocks. Warren Buffett has the perfect temperament for the market, so he can step in and buy when everyone else is selling. His famous quote is “be greedy when others are fearful and fearful when others are greedy” and he is acting on that principle through all of this.

It is not an easy thing to do, though. Most people want to get out of stocks right now, not sit tight or buy more. That is what their emotions are telling them to do. Unfortunately, it is not the right decision to make for an investor who has the time to wait things out for several years.

I will conclude with a story. During the first week of October 2002 I wrote a letter and sent it out to about three dozen friends and family members. I explained that the stock market was very depressed but that there were tremendous investment opportunities out there. I made the case that allocating money with Peridot Capital at that time would likely prove very profitable over the coming years.

Guess how many people invested new money with me? None. The responses were predictable, although I had hoped some would take me up on my offer. Many recipients simply ignored the letter completely. Some responded by telling me that they had sworn off the market after they had lost so much. One declined my offer by explaining “As you know, this is not the easiest environment to lure potential investors.” Very true, but ironically, it was the perfect time to do so.

A week after I sent out that letter, the S&P 500 index bottomed out at 768.63 on October 10, 2002. Over the next five years the market more than doubled and reached an all-time high of 1,576.09 on October 11, 2007.

So my bear market advice in as few words as possible would be:

1) If you have a 5-10 year investment time horizon, or longer, do not sell your stocks simply because prices have fallen significantly and it is scary to watch the daily market swings and read the dire news headlines.

2) If you have the financial means, and are comfortable doing so, adding to your investments during times like these will most likely prove very profitable as long as you can take a long term view on the investment.

3) Don’t pay attention to the daily market volatility and headlines if you don’t have to. If you are investing for 5 or 10 years, who cares what the market does today, this week, or this month? It’s irrelevant. Warren Buffett often says that he wouldn’t care if the market shut down for a few years and reopened because he is confident in the long term prospects of the stocks he owns.

If only we could make that happen in times like these. It would ease the short term pain and also ensure long term gain.

Witnessing History

Can you recall the last time the Dow fell 777 points in a single day? Well, it never has, until today. This post will be brief. I am going to forget about the market and focus instead on the Ravens/Steelers game tonight (I am from Baltimore, but moved to Pittsburgh earlier this year) to try and take my mind off what happened in Congress today. In coming days we will likely see another bill come up for a vote, perhaps better, perhaps worse, than the current one. The Republicans will vote for it and hopefully we can make back much of today’s loss in relatively short order. Hopefully people will begin to realize that this kind of bill does far more than pad the wallets of Wall Street (heck, 40% of the big 5 firms have gone belly up already). The banks we all hold our money with are not Wall Street. Rather, they are the lifeblood of Main Street.

Thoughts on the “Bailout”

A reader asks:

“Curious what your thoughts on the bailout are. Is it necessary and what do you think of its presented form?”

I definitely think something is necessary. The biggest problem I have with the plan is not the concept itself, but rather how Paulson and Bernanke have sold it to Congress and the public. The conventional wisdom on Main Street and in Congress is that we are simply writing a $700 billion check to bailout Wall Street and the rich executives who helped get us into this mess in the first place, at the taxpayers’ expense. I am puzzled as to why nobody has tried very hard to explain how that is largely inaccurate.

We are not writing a check for $700 billion and getting nothing in return. That would be a bailout. Instead, we are buying distressed assets at a fraction of their notional (typo, corrected and replaced “nominal” with “notional” -CB) value. By doing so, we are converting unrealized losses on the banks’ balance sheets to realized losses. How is that a bailout? The banks are going to book billions of dollars of losses by selling their assets to the government.

The whole point of the plan is to determine prices for assets where the market isn’t functioning, so we know what exactly the ultimate losses on this crap are going to be. Without a market for these assets, uncertainty as to actual losses is causing worry and panic in the marketplace. If we bought assets at par, then yes, that would be a bailout because we would protect the banks from losses. All we are trying to do is quantify the losses, which is extraordinarily important.

In return, the government is getting assets that are producing real cash flow. There will be plenty of defaults, but that is reflected in the price being paid (10, 20, 30 cents on the dollar in many cases). The taxpayers are not going to lose $700 billion from this plan. We could lose some, or make some, depending on a variety of factors, but by buying assets when nobody else is willing to, the odds are high that the price paid will be very, very fair, if not a bargain.

As for plan specifics, I like the idea of a reverse auction as a price discovery mechanism. It integrates a market-based system into government intervention. The only thing I am worried about is the incentive system for banks to participate. Very few firms have sold these assets at low prices so far, and I am not sure why they would be more likely to sell to the government. With a reverse auction in place, it is not like the government can bid unreasonably high prices to coax sellers, and they wouldn’t want to do that anyway since they are acting with taxpayer funds.

All in all, I like the idea but not the sales pitch. Too many people either don’t understand why anything needs to be done or are misguided in their belief that all we are doing is “bailing out Wall Street.” The middle class would be among the worst affected should the economy deteriorate significantly further. And anyone who thinks the government needs to leave the market alone simply is not well versed in exactly what started to happen last week, how dysfunctional the markets have become, and what could occur as a result should we just sit back and let the free market figure it out. The free market (and the greed and unethical behavior it promoted) got us into trouble in the first place.

U.S. Economy: Widespread Recession or Financial System Crisis?

Most of the steps taken by the Federal Government so far have been an attempt to prevent the current financial market crisis from getting worse, which would undoubtedly spill over to Main Street and the rest of the economy. The reason why there is a debate about whether we are in recession right now, or whether we will fall into one next year or not, is because the problems thus far are contained to a few areas. If those problem spots can be resolved to any measurable degree, we could get a quick economic and market recovery. If they spread, we are in for a prolonged and expanded downturn.

To see exactly how well most areas of the economy are holding up, we need to look no further than a breakdown of S&P 500 earnings by sector. Below is the breakdown of earnings from 2006 through current 2009 estimates:

Notice what while S&P 500 earnings will be down this year, for the second straight year, eight of the ten sectors are expected to have earnings gains for the third consecutive year in 2008, as well as further gains in 2009. This data shows exactly how much impact the financial sector’s woes are having on the market. The consumer discretionary sector is an obvious casualty of such fallout, but everything else is fairly strong.

Personally, I think 2009 earnings estimates remain too high, though they have come down some already. Although I think the odds are remote, it is easy to see that, when one assumes the financials will rebound sharply, such a high S&P earnings number is possible in 2009 because the other sectors remain on firm footing.

Our economy is not yet in a widespread recession. Financial services are in trouble and are spilling over to the consumer sector. It might not be very comforting, but if we can get the financials consistently back in the black, even if they earn half the amount they did a few years ago, the economy and markets could hold up okay next year and beyond.

Short Selling Ban Is Dramatic, But U.S. Can’t Allow Firms To Fail For No Reason

The SEC’s 10-day ban on the short selling of financial stocks will undoubtedly spark a great debate on Wall Street, and the merits of the rule should be discussed, but let’s be honest, the government had to do something.

Morgan Stanley (MS) reported blow out earnings and a book value of $31 per share this week (a day earlier than planned, due to a sinking stock price) and the stock reacted by dropping 60% from $30 to $12 per share. Another day or two of that and the firm could have filed bankruptcy (and Goldman Sachs probably would have followed), even though it earned $1.43 billion on $8.0 billion in revenue for the quarter ended August 31st.

State Street (STT) drops from $68 to $29 yesterday on no news. The company issues a press release saying nothing is wrong and the stock recovers.

These are not stories of orderly markets that are functioning normally. If not this SEC ban, then what else should they have done to restore order? What are the alternatives?

When traders can have that much impact on a company’s fate because falling share prices for no fundamental reason can lead to bankruptcy within days, or the need to sell your company for a bargain basement price because you have no other choice, that is not an orderly market. It’s that kind of thing that causes panic and could create a 1987-like crash, or worse, a 1929 depression-like crash. If based on fundamentals, those events, while dire, are not something we should prevent. However, the events of this week were not based on fundamentals, they were based on speculators, false rumors, and panic.

I have no problem with short selling. But when unrelenting shorting can contribute to a company falling into a death spiral, a company that otherwise would have easily avoided such fate, I really don’t have a problem with banning shorting for 10 days to make sure our market can function normally.

If short sellers and/or hedge funds want to bet against these firms, all they have to do over the next 10 days is buy puts. If their fundamental analysis is correct, they’ll make a killing from those bets. But those bearish bets should not directly contribute to the demise of our country’s largest financial institutions. Just because Bear Stearns and Lehman Brothers were bad investment banks, Morgan Stanley and Goldman Sachs should not be forced to fail too when they have managed their risks far better and are still in the black to the tune of billions of dollars.

Full Disclosure: No positions in the companies mentioned at the time of writing

UPDATE 9/19 3:35PM ET
Lots of reporting in the media that the rally today is due to short covering because of the new short selling rules. This is nonsense. The rule bans shorting of financials starting today. It does not force previous shorts to be covered. Not only that, if you short stocks and you know you won’t be able to make new shorts for the next 10 trading sessions, and the Dow soared 400 at the open today, why would you cover your existing shorts? If you really believed in your negative view of the stocks, and the prices went up at a time when you were banned from shorting more shares, you would certainly keep the shorts on rather than covering them. -CB

Newsflash: SEC Might Slowly Start to Enforce the Law

From MarketWatch:

“The Securities and Exchange Commission said Tuesday that it will try to limit so-called “naked” short selling of shares in Fannie Mae, Freddie Mac and big brokerage firms. The SEC will issue an emergency order stating that all short sales of shares in these companies will be subject to a “pre-borrow” requirement, said Christopher Cox, chairman of the SEC. This will last for 30 days, he said. The SEC is also planning more rule-making focused on short selling in the broader market, Cox said.”

Is this some sort of joke? Naked short selling is illegal, and for good reason. Short selling involves borrowing shares from holders who are willing to lend them out, selling them, and promising to repay the shares at some point in the future. So called “naked” short selling, or selling shares without actually borrowing them, is illegal because it can result in constant selling pressure due to the sale of more shares than are available for sale.

Now the SEC is saying that “naked” shorting will be illegal for 30 days for certain financial stocks. Seriously? So they are admitting that “naked” shorting is running rampant (a position that has been claimed for years) and they have not been enforcing the law? Add that to the list of reasons why this market could be taking it on the chin. First the SEC eliminated the “up-tick” rule, and now they are allowing “naked” shorting. Shameful…

General Electric Earnings Could Initiate Oversold Bounce

General Electric (GE) will be the first important report of second quarter earnings season. After last quarter’s shocker, a stabilizing picture at the industrial conglomerate could very well help this market get a much needed and long overdue oversold bounce. With sentiment so low right now, even generally in-line earnings might be enough to halt the market’s slide.

Coming into this earnings season, consensus estimates call for S&P operating earnings of $88 for 2008. Interestingly, that would match the market’s 2006 level, and represent an increase of 6% over 2007. A huge headwind for the market has been the fact that earnings estimates coming into the year were way too high and downward revisions have been continuous. Stock prices will have a hard time rebounding until earnings stabilize.

Amazingly, estimates for 2009 are still way too high. Analysts right now are sitting at $109 for the S&P 500 next year, which I think is insane, quite frankly. If those numbers prove accurate this market will be off to the races by the first half of next year. That aside, if second quarter earnings are okay (not far below current estimates) hopefully we will get another short term oversold bounce, much like the two we have already seen during this year’s market ugliness.

A better report out of General Electric would go a long way to getting the ball rolling in that direction (GE reports before the market opens on Friday).

Full Disclosure: Peridot clients were long GE at the time of writing

With Negative Sentiment Soaring, We Might Be Starting A Bottoming Process

One of the stranger things about 2007 was the huge discrepancy between different areas of the U.S. stock market. Despite widespread problems, the stock market didn’t fare badly unless you looked under the hood. The S&P 500 finished the year up 5%, hardly indicative of the issues we are facing. In fact, of the market’s ten major sectors, only two of them trailed the S&P 500 index’s return last year. Financial services (-21%) and consumer discretionary (-14%) stocks were correctly pricing in a recession (or something that feels like one) but the other eight sectors just kept humming right along.

Well, it appears we are now getting a more realistic reaction in the market to the economic challenges we are dealing with. We’ve dropped 10% in less than 3 weeks, and the selling has been much more widespread. Realistically, we were due for this type of action. That said, the negative sentiment in the market right now is deafening. We won’t know how bad things really are until fourth quarter earnings reports and first quarter outlooks are given out over the next 2-3 weeks, but stock prices are starting to price in some really bad stuff. Many contrarian sentiment indicators are signaling we could be starting a bottoming process.

Since nobody can predict when the market will stop going down, I’m not going to waste my time (or yours) hazarding a guess. I will say this, however. Investors should pay close attention to this month’s earnings reports and conference calls. Stock prices are now being driven by fear, and I think many of them are not reflecting what is likely to happen as we navigate through 2008. We could certainly fall another 5%-10%, after all things are not good and I’m not trying to say they are, but we should still be getting ready to pounce.

Personally, I am not going to be doing any meaningful buying until I see these earnings reports and listen to quarterly conference calls. But after that, I think it might be time to dip a toe in the water with cash positions. Even if we keep heading lower short term, a year or two from now I think it will pay off in spades.

Earnings Estimates for 2008 Appear Overly Optimistic

Although fourth quarter earnings reports just started to trickle in, consensus estimates call for 2007 S&P 500 profits to be essentially flat with 2006. Given the huge year-over-year declines in the financial sector, the largest piece of the index, this is not very surprising.

What is surprising is that analysts are projecting 2008 earnings to grow by more than 15%. We all know that analysts are rarely spot on with their forecasts, but the possibility of this number being accurate seems even less likely than normal. While the market’s P/E using the current forward estimate (less than 14) is not high by any means, bullish investors hoping for a solid market gain this year (at or above historical averages) likely need strong earnings growth to make the case.

Given the economic backdrop right now, a less impressive year in the market (more in line with last year) seems like a more reasonable expectation. As far as the economy goes, 2008 probably will be more of a “sorting out” year than a “snap back” one. As a result, I think the return of double digit earnings growth for the S&P 500 likely won’t return until 2009 at the earliest.

Third Time’s A Charm?

Earnings season officially kicked off this afternoon, with Alcoa (AA) reporting fourth quarter numbers. Given the worries about the economy, these profit reports obviously carry as much as weight as anything in determining market direction, but they also come at a time when the S&P has once again dropped down to a support area between 1350 and 1400. Since I am not of the belief that the Fed can cure all of our ills on its own, the next few weeks are crucial to whether or not we can maintain these levels again, or if a wider bear market (not just in financials and consumer discretionary stocks) awaits us.