Uh Oh

From John Hussman this week.
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South Park Weighs In On The Financial Crisis

The recent South Park episode titled Margaritaville does not give the single worst recap of the financial crisis you will find and even if you are not a fan of the show you will probably laugh at least a couple of times.

You can watch online here.

The show is a humorous and simplistic deconstruction of the whole thing but I pulled one other thing out that while funny is also very true and something I have been writing about for ages.

The screen shot I captured is of Randy Marsh in the middle of a lecture/rant to his family about how frivolous spending ruined the economy. He then continues on the same jag and emerges as a leader of sorts with his economic theories. As he stresses that people should only spend money on the barest of necessities he includes margaritas on this very short list of items that are essential.

While most of us can laugh at the idea of a margarita machine being indispensable many of us take on absurd expenses that we are just as blind to as Randy and his margarita machine. The best thing I can say, because I am terrible at actually having this conversation with people, is that hopefully anyone who is as blind to something as Randy is to the margarita machine can muster the introspection to recognize the behavior.

Now a little about the market's most recent sell off. At this point it is unlikely that too many people are having an emotional response to the what might be the end of the rally. At some point on the way down, if indeed that is the direction we are headed, emotion will come to the surface, this is a typical and reasonable human behavior. Getting out in front of the possibility before it happens mitigates the chance of succumbing to the emotion.

I make this same point often because I am convinced that realizing ahead of time that in general markets go down sometimes and more specifically the normal path out of a bear market includes being faked out helps make the ride easier which is crucial to long term success. Those stats about mutual fund holders badly lagging the mutual funds they own comes from selling low and buying high.

In addition to knowing the market goes down occasionally it is important to realize that human behavior is the biggest detriment to long term investing success (no data to back that up, just my opinion). The blog posts on this topic serve as my attempt to get the concept through to readers and obviously clients who read the site.

This is also the motive for taking defensive action, raising a lot of cash when I did and generally wanting to not look a whole lot like the market while the S&P 500 is below its 200 DMA, it makes enduring the event much easier.
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The Government Isn't Running GM?

It looks like the government is forcing Rick Waggoner out and playing a big role in the Fiat deal with Chrysler.

So is the administration playing the role of Board Chairman with GM and investment banker with Chrysler?

I certainly do not have the answers here, not by any stretch, but hasn't Fritz Henderson been part of the senior leadership at GM during all of this and I seem to remember Fiat making very unreliable cars.

I must be missing something.
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Bemidji State=Frozen Four

The NCAA hockey bracket blew up, only one #1 seed made it through, Bemidji was the last team in and made to the frozen four.

Tyler Durden from Zero Hedge gave a rundown of market activity and recent economic data that might send some folks running for the hills. Included in the rundown is a reminder, with some datapoints to back him up, that the biggest up days and the fastest rallies usually occur during bear markets.

We have had some good sized bear market rallies, although I have been expecting a bigger one, and the current one will either keep going or has petered out but it is very likely that the lift that turns out to be the real thing will be met with far less glee than met the start of the November rally and the current one. Michael Kahn and others have mentioned revulsion is an appropriate sentiment to mark a bottom and while there is some of that there is not a lot.

I have no idea if my belief in a monster bear market rally will be correct or not but that is not the point. The point is that if the rally goes from big to monster that you avoid getting overly excited on the way up and if it then fails, turns around and goes right back to 700 on the SPX that you then avoid getting too upset. As this market cycle makes its way to the next bull it is true that more emotion will not make the ride any easier.

On another note Legg Mason may come out with a toxic asset fund. I have no idea if that is true or not but you are no doubt reading about some of the YTMs available on some of this stuff and you might think that sounds pretty good. There is an issue where the banks are probably only interested in selling the worst of the toxic paper versus potential buyers only wanting the best toxic paper. I'm sure this can be worked out but aside from the humorous "do you really want to buy something that is toxic" the decision to buy into a toxic asset fund comes down to one thing, one thing for me anyway.

Why do you have fixed income in your portfolio (assuming you have any)? Are you seeking capital gains or are you looking to manage the volatility of your portfolio? Personally, while I generally believe in spreading out to various parts of the fixed income market I am not looking to make a killing in the bond market.

Can anyone say it would be a black swan event if there was another drop in these prices, more writedowns, capital injections and the like? The potential for big returns carries big risk and the bond market is not the right place for many people to take those risks.

Lastly a rhetorical question; Clearly the misuse of leverage was a huge contributing factor to the financial crisis. In that light is yet more leverage, as put forth in the PPIP, really the best solution?
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Sunday Morning Coffee

Some good stuff in Barron's this week.

First is this assessment of hedge fund manager James Melcher;

"Although he's a believer in the importance of asset allocation, Melcher thinks that security selection has become close to irrelevant -- that there's a greater need for broad market judgment rather than rigid portfolio modeling."

Now keep in mind his returns have been stellar; he was ahead of the S&P 500 by about 80% in 2008 due primarily to knowing what parts of the market to avoid and what parts to short. This is of course the essence of top down management. You may not be much for shorting, I am not, but recognizing when an asset class should be avoided or underweighted, like when demand is unhealthy (US equities) or prices are at all time highs (US treasuries) can make all the difference.

Think about the last two bear markets. Simple recognition that demand for equities was unhealthy (for me this means a breach of the 200 DMA but there are other measures that work) became the most important indicator leading to the most important action that someone could take; reduce exposure. Knowing how much exposure to take off gets trickier but even a little reduction would have helped many people.

This takes me to the comment I cited in this week's video where the reader seemed to conclude that with Yardeni (and he is not alone) saying the bottom is in and Roubini (he is not alone either) saying there is more downside to come the best course is buy and hold.

For some people buy and hold was, is and will always be the best course of action. That is not right for me, not how I write this blog and most importantly not how I manage money. So if you are one of the people continually leaving comments that seem to say buy and hold is the only way to go I will say that the market warned what was coming as I noted in this post from December of 2007 that recaps what I believe are the typical warning signs.

Bear markets typically start the same way; the 200 DMA gets breached shortly after the peak, the market goes down a small amount three months in a row (2% rule) and most of the pundits tell us not to worry. All of these things happened in December of 2007 (and November of 2000 for that matter). This was not a prediction it was knowing what to look for based on how these things work. I had been saying the same thing about what the warnings would be for years; here is a post from November 2004 that says the exact same thing.

Buy and and hold is perfectly valid but the insinuation that it is the only way for everyone is not valid.

The other Barron's snippet I wanted to mention was the following about CalPERs;

"Facing its worst underfunding in more than 20 years, CalPERS is rethinking its asset-allocation models. It might even change its view of "alternative" investments, such as real estate, hedge funds and private equity. That would be important, because CalPERS has been a lead goat in a multidecade dispersal of employees' and universities' wealth into those alternatives."

Having too large a percentage in illiquid alternative assets has come around to bite many big endowments and pensions during the bear market. I have been a big believer in alternative asset exposure for quite a while, have written many posts to try to explore the concept and believe a modest exposure can improve the risk adjusted result. As is the case with all "sophisticated" investment tools too much becomes risky and eventually has big consequences.

Many clients have two open end mutual funds that are in the long/short segment and the two funds total maybe 5% of the portfolio. I view commodities in a similar manner with most clients having 3-5% spread between gold and agriculture. The line between diversifier and big bet may not be so thin but it is subjective. While I could probably go a scosh heavier I know I do not want to exceed 10% in these sorts of things because when the do have a bad run, which may not be very often, they get crushed.

What a day for sports yesterday. Virginia v Maryland went 7 OTs in lacrosse, North Dakota v UNH hockey was pretty good and how about Nova taking down Pitt, wow.

My wife is heavily involved with dog rescue. She got this shot of Merlin who is obviously a Basset Hound at yesterday's adoption event. Just seeing that blue toy lit him up with excitement.
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Just Because

Does anyone know what was going on in that video?

Dylan Ratigan has left CNBC, hat tip to Adam and Barry and a double hat tip to Adam for posting this same video.
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The Big Picture For The Week Of March 29, 2009

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Friday Chilaxing

Spring is in the air, the NCAA Tourney is in the sweet sixteen round and market participants (almost) everywhere are breathing easier as the rally continues to lift prices. Before anyone gets too worked up, this rally is either just a feel good rally or the real thing, we know it is one or the other. If we know that it is one or the other then there is the very real chance that it goes back down after it tops out. As we understand this now while prices are going up then there is no reason to freak out if it does go back down quickly.

Your drug company will still sell medicine, your industrial company will still sell widgets, your utility will still deliver power to its customers and the odds are overwhelming at this point that your bank will still take deposits and honor your checks. None of that tells you what direction the next 20% will be for the stock prices and for most of us it does not truly matter.

Different subject; I found this article on Yahoo Finance yesterday about talking to older parents about their finances. Asset prices are down which quite obviously threatens income streams so maybe we in our 30s, 40s or 50s need to talk to our parents.

It was a fine article but I also think many people need to talk to themselves about their own finances, more specifically having realistic expectations for portfolio results, having the introspection to recognize limitations of investment ability and most importantly, I say most importantly (channeling Foghorn Leghorn), reassess every aspect of their spending habits. I am convinced this will be a bigger cause of financial plan failure than anything else.

This is difficult to take to heart but this is an issue for most people and usually when I try to have the conversation with someone it doesn't go well (can't rule out my poor communication skills as a cause). Some folks don't view their extravagance as expensive, some expect the market to bail them out, some expect to spend less when they get older and some are in another form of denial. I know this falls on a lot of deaf ears, but I'm telling you...

Thanks for all the comments yesterday about the CNBC visit.
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Me On The TeeVee

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CNBC

Well, I am not a handsome man but they want me back anyway.

I am scheduled 40 minutes past the US close today so it could be plus or minus a few minutes.
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FT To Investors: Fuggettaboutit

That title might be a bit of a stretch but there was an excellent writeup in the FT yesterday by John Authers that questions the assumptions about equities that are held dear by all many investors, both professionals and do-it-yourselfers.

Authers refers to multiple quotes from a Rob Arnott article due to appear in the Journal of Indexes. A big take away is that "the cult of the equity" has let investors down. Also the efficient market hypothesis cannot be applied to the last 18 months.

The charts included in the article are pasted here and contribute to the argument that it may be a while before equities work again. Reader Clive left a link to essentially the same chart a few weeks ago.

Read the article, I can't do it full justice with a recap.

My first thought is somewhat snarky but with more and more people telling us that equities may not work it seems like maybe we are getting to a point sentiment-wise where equities should be be bought with both hands for what could be a Q2 1933 type of rally (the market doubled in about three months 54 up to 106). If equities truly are broken, which is not what I believe, then shockingly violent spasms in either direction would not be a surprise. This not a prediction so much as contrarian thought.

Perhaps the more practical way to think of this is something I have been writing about for a while in terms of evolution of portfolio construction. If your financial plan calls for 7% as a mid-line number for success you can still get that number even if it means owning less straight equities. Averaging 7% may mean including commodity exposure, absolute return exposure, thematic exposure, foreign currency, foreign debt, exposure to countries that are more in their own worlds or other things.

My view for several years has been that US equities will still go up but at a lower average annual rate than what we have been accustomed to. This means having more exposure to the things listed in the previous paragraph, less reliance on broad-based products like SPY and EFA and more reliance on narrow products like sector, sub-sector and country funds, individual stocks, specialized mutual funds and maybe types of products that do not yet exist.

If this scenario pans out it will require more work but I believe it could deliver a better risk adjusted result than passive investing. The extra work required would be in terms of research, understanding how things trade and how to blend various products together to get a volatility you can live with. Just because it would be more work does not mean it isn't doable, I've been writing about this stuff for four and half years. If I can begin to understand this stuff you can too.
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Retirement Planning Bugaboos

There were a couple of interesting articles that although the topics were different, tied in with each other in an important way. The first was a writeup by Rob Arnott and John West at IndexUniverse that updated the active passive debate.

According to the article a 60/40 mix, with the proxies being SPY and AGG was only down 22% in 2008 compared to a 21% decline for Hedge Fund Research Institute's Hedge Fund of Funds Composite which the authors described as the ultimate active management vehicle. Perhaps their conclusion that the lack of value added by most active managers will send more people to passive investing will be correct but it is not clear to me that a hedge fund index should be compared to a 60/40 portfolio. As Aaron Pressman recently noted a 70/30 mix was down 25%. The greater the equity exposure the greater the decline and while I do not know whether a hedge fund index is best compared to a 90/10 mix or something else I do not think 60/40 is the correct comparison.

The article got me to look at the price action and dividend payouts of three different bond ETFs; AGG, MUB and GBF. Other than a violent spasm last fall in which many ETFs moved sharply away from their respective net asset values the price action was pretty steady in those three, that's good. However the dividends, all three are monthly pays, have gone down considerably for AGG and GBF. I'm not sure that a reduced payout can be factored in to the down 22% number cited in the article but if in the simplest world possible you had 40% in AGG and the dividend dropped 17.5% that could have a big impact if the portfolio was used to generate income.

With individual bonds treasuries and agencies have probably done OK but other parts may have declined in price depending on what was held and so the value of a 60/40 portfolio could be worse than down 22%. But that would not be an indexed bond portfolio an indexer would say. While that is true it has been pretty easy to beat generic bond indexes for most of this decade and so looking at a longer period of time might be constructive than cherry picking the worst year for the market since the plague set upon Europe.

On a related noted there was another article by Robert Huebscher that dissected the 4% withdrawal rule for people living off of their portfolio. The take away is that depending on the rate of inflation, retirees can take more than 4% out and still be safe. He makes all sorts of assumptions that I would not make but he does tell readers that he is making those assumptions and why he's making them. Fair enough.

Personally I am not on board with assuming inflation will remain at a certain level or that a state cannot default (think muni bond holders), not that he was advocating wild risks in a portfolio, just relying on a few things for his numbers. It is definitely worth reading.

My take all along has been to take 4% of what ever you have per year (more specifically 1% per quarter) and not increase the amount for inflation. Hopefully a balanced portfolio will keep up with inflation (the last 12 years notwithstanding). There is another element to this that I have touched on before but do not see addressed often enough that threatens even 4%; one off events.

This month we had a $254 vet bill (Tater's teeth cleaning and shots for Trixie) and needed to replace our kitchen faucet for $117 which I replaced myself (very easy project), in February we spent about $100 at Home Depot, last fall we had $1300 worth of work done on our 4-runner (nine years old but this was cheaper than a new SUV), last summer we needed tires for the pick up, about a year ago we needed a new vacuum; you can see where I am going and those are only the things that I can remember. It would be easy to have $5000 worth of one-offs every year. That can be a significant number depending on the income level. Even someone who has to work hard to live on $100,000 per year could have trouble covering $5000 worth of surprises.

These things cannot be accurately budgeted for (god forbid this is the month you need to buy ink cartridges), do not decrease in retirement and can come from anywhere. Any time I have a client ask me something about this subject I always say the same thing, "you have to do what you have to do, it is better for you to spend as little as possible doing it."

All of the work anyone does with their investing, the sacrifice they make with their saving and their willingness to work one way or another during retirement is about increasing their odds of not running out of money. There are obstacles with all of these. The biggest obstacle to investing is the human emotions that cause people to want to sell low and buy high. The biggest obstacle to saving is spending habits which is a tough one to overcome as very few people actually think they spend too much (there would be no telling Joellyn and me to not have dogs). There are two obstacle to working longer; some folks are unable and some others simply don't want to.

Overcoming these obstacles, and any others I am not thinking of, guarantees nothing but it does increase the odds for success.
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Chiggity Check Yourself

At 822 the S&P 500 is down 8.9% YTD. Someone doing well thus far might be able to see breakeven versus December 31 and anyone struggling a little might be down low double digits. With that sort of range, anyone prone to emotion is probably in a less emotional state than they were two weeks ago. The sigh of relief I'm describing could promote some clearer thinking.

It would have been reasonable to see a stock owned trading at an absurdly low price and to wonder why it was still in the portfolio and to further think "geez if it gets back to $X I'm going to sell it." For most stocks, selling when it gets back to $X is probably the wrong trade for the long term.

One of the two mining stocks in my ownership universe (both are down a lot) got down to a sickeningly low number before bouncing 60% in about ten minutes (intentional hyperbole). Quite frankly, most of the stocks that you or your friends or your neighbors are worried about are going to survive and go on to make new all time highs. This is a point I have made before with the caveat that the time needed may end up seeming like too long or not be that bad, we'll see.

Let's pick a name at random that I do not own and have no plans to own; Deere & Co. (DE). At the current price it is down close to 2/3's from its high. At its worst it was down 3/4's and is now up 41% off of the low. According to Yahoo Finance it has earned $4.38 in the trailing 12 months and is estimated to earn $3.23 in 2009 and $3.07 in 2010. Even if you slash those estimates dramatically because you distrust the analysts the company is still very likely to eek out a profit while being able to service the debt--it does have a lot of debt BTW.

I'm not making a case to buy the stock, I'm making the case that it won't go to zero. Won't go to zero is not a reason to buy. I'm sure there is a bull case for the name but this is really just an example. Many of the people who own this stock are down a lot as you probably are with most of your stocks, as I am with most of the stocks I own personally and for clients. In my opinion there is no question that DE will work back to that high again as will many stocks but I have no idea if DE will make it back faster or slower than the market.

More important that stocks being down a lot now is defensive action taken hopefully early on in the bear cycle.

The point of all of this is selling a stock just to sell because it is down a lot is very likely the wrong trade. This is not to say that you shouldn't adhere to some sort of defensive strategy or consider reducing exposure after a a big rally in this environment. This is subtle and I may not articulate it well but the mind set of if ABC gets back to $X per share I'm out is more about emotion than logic as opposed to after an X% bear market rally I will reduce my net long exposure by adding an inverse fund or reducing exposure to something that bounced on emotion not reason or both. Hopefully that distinction is clear.
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Expert Analysis Of Today's Rally

I like to move it, move it!
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The Future of Infrastructure

In this weekend's video I did a brief recap of my time with the Macquarie Infrastructure Trust (MIC) and what has happened with a couple of their CEFs in this bear market.

A reader asked how should the infrastructure theme be accessed given how badly the Macquarie products have done. The reader presumes that the theme is worth allocating to and I agree.

There are several ETFs but they each target different areas within the space. The SPDR FTSE/Macquarie Global Infrastructure 100 ETF (GII) is 90% utilities and so tracks closely with that sector. The PowerShares Emerging Markets Infrastructure Portfolio (PXR) is 40% materials and perhaps confusingly has non emerging market stocks in it (a company that sells to emerging market countries can be included). The iShares S&P Global Infrastructure Index ETF (IGF) is mostly an even mix of industrials and utilities with a little pipeline thrown in. Included in IGF are some of the cash flow segments like toll roads and airports. I use IGF in some portfolios.

IGF is down a lot, but less in the trailing twelve months than the Industrial Sector SPDR (XLI).

One way to buy in, but not what I am doing or will do in the future, would be to use GII as a proxy for utilities, PXR for materials and IGF for industrials (IGF has tracked much closer to industrials than utilities). All three funds track their corresponding sectors closely enough that I think they are suitable sector proxies with the hope of outperforming whenever the theme starts to matter.

I think of this as something to unfold over most of a decade like emerging markets were in the oughts (or if you prefer the naughties). In looking ahead like that I believe that the theme will be best captured by including individual stocks into whatever you do. IGF and PXR include a lot of stocks that will build the roads or provide the technology needed for any sort of project but they aren't that heavy in the cashflows that the engineers and systems company will be creating. Actually IGF has about 25% in these stocks. For now, building the stuff is probably more important than the cashflow from the finished product but that will not always be the case.

Just a couple of thoughts about the tourney. There were some great games, especially late Friday night, the Gonzaga/WKU game on Saturday and all three late games on Sunday but up to this point there seems to be fewer great games. Does anyone else think Bill Raftery and Vern Lundquist should be the network's announcing varsity instead of Jim Nantz and Clark Kellog? While I am biased here, Nantz and Kellog are like dry toast.

Finally news from Walker; there is a movie shoot in the house three doors down from us. They have been in pre-production there for a couple of days, including an electrician coming out the other day. A friend who knows about these things said with all of that it probably is not low budget, I have no idea. Joellyn asked one of the people what kind of movie and he said horror but Joellyn said that the way he said it made her think it was another genre if you, um, know what I mean.
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Sunday Morning Coffee

Michael Steinhardt was on Squawk Box on Friday morning and had a very interesting comment that I have transcribed below off of my DVR.

Carl Q: But Michael, you on the other hand think there is not enough information to make a call (on the broad market) and my question is the fallout from that just to stay in cash and stay out of the markets completely?

Michael Steinhardt: I've been in the market all my life, and I focused on projections all my life and I have always taken great pride in being right and I don't open my mouth unless I think there is a reasonably high probability that I'm going to be right and I'd say most people are random in their judgments and are perfectly happy to express their views no matter what.

So with that background I would say it is a very difficult time to make judgments. I think Lee (Leon Cooperman) is a very smart guy but if we are sitting here six months from now it is at least 50/50 that he will have a different view then he has today because it is just a strange difficult time because there are too many imponderables and too many things that are going to change that we can't anticipate now.

So I would rather be liquid for sure to be liquid be relatively risk adverse and just hang in and say most of us have lost a lot of money in the last year and I'd rather not lose some more.

It doesn't sound like he is too worried about timing a turnaround and is quite content sitting in what sounds to me like a defensive position. My two cents here, which I have said often, is that there are times to let your money grow (most of the time) and other times where protection of assets are most important.

I found this by Chuck Jaffee at the site for the Fort Worth Star Telegram (so presumably it ran on MarketWatch first) about the potential importance of the sale of iShares by Barclays Bank. The article explores whether the sale would create a new ETF powerhouse and whether this is a path to active ETFs.

Many agree that active ETFs are the next big thing but I have never understood the appeal. In a manner of speaking we have had active ETFs for decades; closed end funds. Obviously there are structural differences. The biggest and most popular ETFs (SPY, EFA, EEM and IWM as examples) are used by large pools of capital because they are fast, easy, liquid proxies. The levered, inverse and certain sector ETFs are used the same way but also for speculation. Beyond that there are the majority of funds (including a couple of active or quasi active) that do not trade a lot.

Maybe I'll turn out to be wrong about this but given the difficulty that so many mutual funds have beating the market I doubt a new, more expensive exposure can gain much traction. One point I have made about ETFs is in the context of portfolio construction and being able to rely on what a given ETF will look like six months from now. There is no way to know what an actively managed product will look like in six months. I would note that any active ETFs will be transparent.

What if it ends up being overweight the wrong sector and at the same time another fund you own is overweight that same wrong sector. It would be like owning both the Legg Mason Value Trust (LMVTX) and Davis NY Venture (NYVTX) in 2008. Those funds were down 55% and 40% respectively that year.

Lastly Barry has a post from John Mauldin that excerpts an op-ed in the WSJ by Gary Schilling and Richard LeFrak. Basically the idea is to give a green card to any immigrant who will buy a house. The idea is interesting and would probably, as the article asserts, stabilize things. But for how long? A commenter on the post said that it would simply delay the final result however bad or not it may turn out to be. This probably also has truth to it.

What do you think?
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The Big Picture For The Week Of March 22, 2009

The Wall Street Journal article mentioned in the video.
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Keepin' It Random

Aaron Pressman has an interesting take on the recent performance of David Swensen's model portfolio.

• 30% US Equities
  
• 20% REITs
• 15% US Treasuries
• 15% TIPS
• 15% Foreign Developed Equities
  
• 5% Emerging Market Equities

According to Aaron this mix was down 32% "over the past year." Aaron came up with that number using broad based ETFs as proxies for each of the six. Aaron also finds a flaw in Swensen's comments about rebalancing the above mix.

I've never had anywhere near that much faith in REITs, the first post if mine I can find questioning Swensen's 20% allocation to REITs was a little over a year ago. I also disagree with no commodities.

As I mentioned once before Swensen clearly had something in mind with this and I would expect that the vast majority of the time it works well, I would note it did outperform the S&P 500 in the period studied but that is not the best benchmark for that portfolio. To the extent someone would be disappointed with a 32% decline in a down 39% world I think this contributes to the case for a defensive strategy and not just relying on a diversified portfolio.

There was an article in Vanity Fair (so it was very long) called Rethinking The American Dream that might make someone who is over-extended feel rather glum and validate someone who lives below his means. I don't know how many people reading this blog have been or will be directly impacted by this Great Recession (not sure who coined it but this name might stick) but life is much easier if you don't have to worry about covering a $5000 mortgage and two $700 car payments. If you had no mortgage payment and no car payments how long would $6400 last? Those numbers are probably a tad high for most folks but you get the point.

Hopefully you know this first hand but your financial life will be much easier if your expenses are low.

After a pronounced move higher for the last few days the market took a breather yesterday with financials dropping the most. This does not mean the rally is over but I think it was a good reminder that it is unlikely the problems in the financials are over. The iShares Financial ETF (IYF) rallied 43% from its March 6 close through Wednesday. When something moves that much people get excited and project forward and it becomes easy to get caught up in the excitement. If you find yourself saying "yeah, he's right" and the next thing you know your logged in and clicking you're probably reacting to emotion rather than executing on logic. If the rally continues higher we will all be confronting more of this.
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Didn't Think Of That

From Marc Ostwald of Monument Securities via the FT;

As for Bernanke’s cherished principle of transparency, that has now clearly been thrown overboard, and by opting to enact this just days after Bernanke expressed the view that the US economy would recover in 2010, Mr Bernanke’s credibility is shot to pieces.

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Great Day In The Morning...

...It's tourney time!

A few more random items today.

The Fed announcement seemed to do a couple of things. I heard one pundit say this means this will not be the 1930's, that is now off the table. I hope that is true but from a stock market perspective that maybe kinda sorta already has happened; two 50% declines in one decade (I realize the first decline in GD 1.0 was much worse). Or maybe not.

Another byproduct of the announcement is that bond yields gyrated violently and the dollar tanked. I'll try to sort out the issuing of debt on one hand and buying it back on the other monetize another day but in terms of dollar weakness there was a stretch where equity returns could be had holding certain currencies or short term sovereign debt.

Before the dollar started this long (what I think is a) counter-trend rally I was able to get something close to 20% from Norwegian sovereign debt. I believe this type opportunity will come around again. I am not worried about trying to time such a thing so I am not worried about when but I do believe this is an important concept.

That is not a call to lopside into that part of the market but some exposure could do some nice heavy lifting.

On the way home from the gym yesterday I caught some of Fast Money on Sirius. The gang sounded all fired up thanks to the rally currently underway. I put up a post yesterday about the SPX taking back 800 for a short while. After such a big move, but far from historic for bear market rallies, it makes sense for some folks to get excited and extrapolate further. I have been writing about a big rally for a while, my timing was probably wrong, and this might be happening now. We'll see. If we get to 900 on the SPX on this move I'm going to post something like "if you were scared to the point of being very upset at SPX 675, 900 is a pretty good time to sell a little something." A little something will not mean go 100% cash.

Did you see the Barack-etology segment on ESPN yesterday? About the only thing I like about him is that he is a sports fan. If you saw the segment you know he really knows his stuff about college basketball. He knew that Ty Lawson has a bum toe and the Oklahoma is not very deep among other things. He said he plans to sneak a peek at the games today and will watch the final game. Um I would think he might have a little more on his plate than to know that much about college hoops. I know what you're thinking, someone briefed him before filming. OK, if that is correct then I'll say "Um I would think he might have a little more on his plate than to spend the time on that kind of detailed briefing about college hoops. Do I have this wrong?
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Looky There

SPX 800.

Bear market rally or the real thing?

Don't forget that bear market rallies have the capacity to be huge.
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Wednesday Randoms

By now you know that Jeremy Grantham's latest missive says the fair value for the S&P 500 is 900 but that there is a 50% chance of "crossing 600." The main focus though is that now that the market is down a lot and realizing that buying at the bottom is problematic for several reasons (including emotional paralysis and just not knowing where the bottom is) we should have a game plan in place for reequitizing.

I think this is akin to what I have been saying for a while. It is a good bet that when the bear becomes a bull there will be a big rally in a short period of time that will be easily missed for fear of it not lasting. This is pretty much what happened in January 1991, 2003, could have been the case with the rally that started in November 2008 but turned out to be a headfake and could be the case with the rally that started at SPX 666. I don't know if last week was the bottom or not. while I have opinions I prefer to not be in a position of having to be right. I told clients ahead of time that we would try to miss a chunk of the bear market decline and that if successful we would lag, but not miss, the initial snapback.

A small meme hopping around the webnets this week has been Nouriel Roubini's portfolio Eddy Elfenbein and Felix Salmon each weigh in on this. Apparently Roubini's 401k is fully invested in index funds but outside of his 401k he is all cash.

The thread then goes into a discussion about working and saving which I think is a great topic. Last April I wrote how important saving is versus performance. The obvious counter argument here is the compounding effect that is captured in your older money, so to speak, but it has been a while since investors have benefitted from compounding, may be a little while longer and a theory I have been working with (and written about a few times) for a long time now is that longer averaged annual returns will come down some from the 9-10% area. This makes a higher savings rate crucial--the paradox of thrift notwithstanding.

This chart is the handiwork of the crew over at Bespoke Investment Group. I find it striking how much longer the declines last versus the rallies. This has obviously been a horrendous bear market but I find the numbers to be stark.

Bespoke also noted that even after this recent rally the S&P 500 is still 4.33% below its 50 DMA and only 27% of the SPX components are above their respective 50 DMAs. Good stuff.

In a related note, John Serrapere makes the case for the rally to run up to SPX 850-950 in the next couple of months.

Lastly, congrats to Morehead State for winning the opening game of the NCAA tourney, they took Alabama State to the shed. I think the 64 vs 65 game is a great thing because it gives a tiny school from a lesser conference the chance to win a game in the tourney.
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Erin Go Bragh!

Today I wanted tackle a couple of things from the media yesterday; one on TV and on from the LA Times.

Two different commentators on CNBC said that stock valuations are cheap. I would urge caution there. We don't really know if valuations are cheap. For many companies we do not know the E in P/E we also don't necessarily know the book value for many companies either. We still have writedowns to come, credit card debt looms as a threat (so says Meredith Whitney) and if we are truly moving to a deleveraged world then ROE for many stocks could come down as well.

Most of the above obviously pertains to financial stocks but I do not think the cheap valuation argument is the best way to look at it.

However stock prices are low, not that they can't go lower but they are low. Selective stock picking at these prices (even 100 SPX points higher than here) will look like very good purchases at some point in the future. The dilemma is not that many companies go to zero, some will but it won't be hundreds, probably not even dozens, but that stock prices could go down another fill in any percentage that makes you uncomfortable is what creates fear. Even after the depression stocks came back. Some folks think this is a as bad as the depression, I do not, but either way stocks came back and made new highs eventually. I am not making a call to buy them with both hands here but major portfolio selling here is very likely the wrong thing to do given the market has already dropped 50%.

The other item was an article in the LA Times that questions whether long term investing works or not. For most people, the article says, 12 years is a long time referring to the fact that we are about where we were in March 1997.

The author makes a couple of group-think comments that belie a lack of some understanding. He asks;

What if the next 10 years are like the last 10 for stocks, or not much better, before some glorious new era of growth arrives in 2019?

He then sort of answers the question;

If you're 30, you can wait. If you're 60, it may be a bridge too far.

While the odds of this 12 year round trip to nowhere turning into a 20 year round trip to nowhere are slim its not like the S&P 500 will stay between 730 and 760 for ten years. After bottoming in July 1932 the Dow rallied from 40 to 78 in three months. Then it dropped back to 50 in four months before going to 105 five months later. After that the moves were smaller in a sideways pattern before going up more slowly for a couple of years. It then cratered from July 1937 to April 1938.

The article validates the decision to get out of stocks now. I have no idea if the author wrote about any sort of defensive strategy before things turned but as uncomfortable as it may be "Running away from stocks now is the safe thing to do if you can't bear the thought of another meltdown" is simply the wrong thing to do. Implementing a defensive strategy after a 50% decline is the epitome of selling low.

The point of all of those posts about the 200 DMA was to avoid the very predicament the author assumes people are in.
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"It's More Akin To Printing Money."

I shuddered a little bit when Bernanke said that on 60 Minutes last night. I realize the Fed has been printing money to try to fix this but there was something about hearing him say it...did you get a similar feeling?

I was struck by a couple of things from the interview. He recycled a couple of nuggets like the burning house analogy and he said again how angry the AIG situation made him. He said this before of course but that just seems like an odd thing for the situation; anger. I'd rather the Fed Chairman was a robot in terms of emotion.

The world is microscopically dissecting everything he says and so the points I make above probably mean nothing but still...

That none of the banks will fail is good for main street of course but he seems to have no allegiance to stock prices of any of the banks, not that he should. A winding down of a financial institution as appears to be happening with AIG will probably leave other stocks at zero or taken over close to zero like Bear Stearns and Washington Mutual.

"Green chutes" notwithstanding I did not get the feeling that this will be over soon. Not over soon does not have to mean everything gets worse although it seems like unemployment will indeed get worse. Between here and the resolution there will be ups and downs in the market (don't laugh, I mean the potential for big moves in both directions that make navigation difficult and weighs emotionally on people) and the eventual real turn around will be met with disbelief.

What did you think about Bernanke last night?
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Sunday Morning Coffee

A couple of things from this week's Barron's.

First is some comments about China in Alan Ableson's column. Decoupling is a myth.

He cites commentary from Albert Edwards of Société Générale (you may remember him from the TV show Green Acres) who believes that we should be suspect of the GDP projections, believes that the contraction in the trade balance is troublesome and that their stimulus targets the wrong thing (infrastructure not the consumer).

GDP has slowed down and their 8% target is not an apples to apples of how other countries measure and the folks at RGE Monitor note that GDP is likely closer to zero if it were calculated in the same manner as other countries. Trade numbers for all of Asia have been contracting at shocking rate. And as far as the stimulus not targeting consumers it is likely that there will be tens of millions unemployed as factories go idle.

So I do not dismiss what Edwards says, he may or may not be drawing the correct conclusion from this information. However I believe this misses the point. Decoupling in the way most people used the word a couple of years ago was more of an unrealistic expectation than a myth. When the world wasn't quite as flat as it is now it would have been easier for more countries to avoid the type of global economic event currently underway. I suppose there might be a couple of countries that are in their own world enough that they could avoid something like this (what's going on in Cypress? Joke, that market has been crushed too).

I have been making the same point for years which that a country isn't likely to avoid a worldwide slowdown but there are more than a couple that could reflect a slowdown later than the US (check out some of the commodity countries that peaked six to eight months after the US) and a few countries that could turn back up earlier than the US and although it is too soon to know for sure there are several countries now that may have actually begun a new bull market including China. Again time will tell.

I have been very public about what I have done with China for clients which to recap was out in Q2 2007 (a few months too early) and back in in November 2008 (a couple of weeks too early) with one stock at a 2% target weight. I have one more name I could pull the trigger on to increase the portfolio weight to 4% but have not done so yet. I got in when the Shanghai Composite was first down 60%. It then went on to be down 70% from its peak and has since worked its way higher.

Edwards concerns are all valid, they may play out in the economy for a while yet but when a market drops 60-70% it discounts in a lot of problems. Remember that what is going in the US and Western European financial systems is more severe in terms of bank failures and the like than in other parts of the world. In that light while other markets are down similar percentages in sympathy the fundamental deterioration is not the same.

The other Barron's snippet is a little lighter; a favorable write up on DirecTv Group (DTV). One of the catalysts according to the article is the stickiness of the NFL Sunday Ticket package which I think is kind of funny since I just ordered the Extra Innings package to watch the Red Sox. I don't own the stock.

The picture is in the Grand Canyon.
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The Big Picture For The Week Of March 15, 2009

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Back In Arizona

There was an interesting article in the Washington Post (via IndexUniverse) on the active/passive debate which included some model portfolios from Burton Malkiel and Larry Swedroe. Malkiel allows for a little active management in certain instances but Swedroe says no dice.

Swedroe had a great quote in there that I agree with wholeheartedly; "Investing is really very simple -- it's just not easy because emotions get in the way." The discussion of active versus passive is always a good debate. Each one has flaws and each has its attributes.

With active management the biggest potential flaw, IMO, is that the person making the decisions gets some things wrong or goes on a cold streak. Every active manager will get some wrong of course or otherwise have a cold streak, the timing of the cold streak matters as does the consequence of the cold streak.

One thing I have talked about many times before is not letting the extent to which you get something wrong be ruinous to the portfolio. Actions that could be ruinous would include 30% in emerging markets or a large weighting to anything that is so volatile that an implosion in that area creates intolerable volatility for the overall portfolio. One example from a couple of years ago was when Canada announced changes to the tax laws for the royalty trusts and they all got crushed. This example is a good one because it the rest of the market is doing ok and this one little group blew up for a little while. Another example from a reader a couple of years ago who practically wiped out for owning too much of one biotech that did not get the FDA ruling it needed.

I've been taking another run at Fooled By Randomness and this is a point that Taleb made, it seems like common sense but many people put themselves at risk of being undone in this fashion.

With passive management the biggest potential flaw, IMO, is that if you really are passive then the equity portion of your portfolio will feel every bump on the road to down a lot. At some point I'm passive, I'm passive, I'm passive might lead to giving in to emotion and selling in desperation at precisely the wrong time.

It is going to be a good March. Six overtimes in MSG last night! Did you stay up? Syracuse had to give a lot of run to a walk on, that's how depleted they were. Crazy.
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Levels Ratios, Jerry

John Serrapere has a new post up at IndexUniverse called Knowing Your Portfolio's Limits that is a good read.

Of most interest to me was the discussion of comparing related items to look for a stealth change in market direction.

The broadest based one of these I know about and have touched on before is small cap versus large cap. Small cap does better at the start of a bull market so small cap outperforming is an indicator worth following--of course no guarantee.

Serrapere highlights a few others that make sense. Junk bonds versus corporates and either one versus treasuries can be useful, this is usually done by observing spreads but that can be difficult to do in terms of accessing the information but comparing ETFs like HYG to LQD (as Serrapere does) captures essentially the same thing. When something like LQD lags riskier parts of the bond market then things could be turning up and conversely leadership from the safer bonds indicates something bad coming.

Serrapere also like to compare the Nasdaq 100 to the iShares Consumer Goods ETF (IYK) which is a proxy for staples and which I own for some clients. Tech is obviously more aggressive while staples are defensive. I imagine this could be done with other sectors too like maybe healthcare.

A question I have is if going narrow for this sort of information creates noise that leads to the wrong conclusion. For example utilities are defensive but are vulnerable to rising interest rates. Of course since he doesn't mention utilities, maybe I have answered my own question; potentially noisy sectors are not used in this sort of study.

I am obviously a big believer in messages of the market hence my having written about the 200 DMA and inverted yield curve hundreds of times. The ratio work that Serrapere writes about is important because turns happen before people start to talk about them (sort of a by definition point) but it is in these sorts of stealth indicators where the best information can be found. For example the 200 DMA was breached for good in November 2000 and December 2007 (it was tested a couple of times after Dec 07). While I am not sure about this bear market, things like the tick, breadth and various measures of divergence started warning of big problems in 1999.

The market gives signals like this, they guarantee nothing but I believe they are worth learning about and heeding.
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Let The Sun Shine!

Not much can capture the joy of a 6% rally like the Aquarius song from closing credits from the 40 Year Old Virgin. Thank goodness the bear is over, the financial crisis is over and we can buy them with both hands (that was sarcastic).

As has been mentioned many times the biggest up days occur in bear markets not bull markets. That does not preclude bear market rallies of all sizes from happening. At the beginning of the year I opined that we had a very good shot of a very big bear market rally and while the timing of that was wrong, big rallies, sometimes huge rallies, are part and parcel of bear markets (see 1932 and 1933).

The decline in the stock market from the 2007 peak has been incredibly fast and incredibly severe. While I have no idea whether yesterday will be the start of something really big or a one day wonder I do believe we will have a huge rally at some point that makes people start to feel good again followed by another big decline that scares the hell out the same people who felt good on the way up.

Forget the emotion, look at a Stock Trader's Almanac (or the max DJIA chart on Yahoo Finance) to see the extent to which feel good rallies followed by more tears repeats in every cycle including the Great Depression (repeated for emphasis). For those worried that this is the great depression 2.0 keep in mind a huge sucker's rally has nothing to do with fundamentals, they are short-ish term events driven by emotion.

Instead of more tears if things play out the way I think (up a lot followed by another big run down) it makes sense to remember how these things often work so you won't be surprised in case the next great bull market is not upon us. Some folks might want to think about reducing their equity exposure after a big run up either for tactical reasons or for the I-give-up reasons cited yesterday.
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That Depends On What The Meaning Of Is Is

In response to my saying yesterday that the market will come back at some point reader Clive asked "come/go back to where? The late 1990's highs?"

The context was the S&P 500 and by extension investor's portfolios. "Come back" can be objective; 1565 on the S&P 500 which was the closing high in October 2007. "Come back" can be subjective; some portfolio level where the investor no longer feels his entire financial plan is upside down.

Anyone who is serious about giving up on stocks needs to realize the point in the cycle at which they have decided equities are not for them; after a 57% decline. Plenty of people were worried/emotional after a 30% decline so at down 57% I do not doubt the emotional toll taken on some participants. But the decision to give up is driven at least in part by emotion.

If after getting your hands around the emotion driving this you still want to give up then you probably need a game plan that involves selling a little bit at regular intervals as the market goes back up--whenever that might start.

This sort of approach would do a couple of things. One is that the stock market will continue to exist, it will continue to go up most of the time and occasionally go down a lot for some reason even if this one is worse and takes longer to start to meaningfully recover. So from the continue to exist camp a systematic sales process would allow recovering a little more than by selling it all now. It would also give you time to let any emotions go back down and maybe look at it a little more rationally.

On the Seeking Alpha version of yesterday's post a reader asked that if 2007 is 1929 then didn't it take until 1954 to get back to even implying, by his math, an average annual return of 3%. In that light why not change your allocation now. As I am in Hawaii I do not have my Stock Trader's Almanac. That disclaimed, this was my reply;

I don't think that (2007=1929). But if you do look at a stock trader's almanac at how huge some of the up years were during that decade, the biggest in the 20th century. Normal stock market behavior, and keep in mind this was exhibited in spades in the 30s, includes large retracements after huge declines. Not to say that we would not go back lower after a huge retracement but there will be a couple of these along the way at some point. Then would be the time to adjust IMO.

For what it is worth I do not think it is the end for stocks. The decline has been severe and there is no way to know how long it will take for this to end. I have opined along the way about magnitude and duration but I am pretty sure I never said that enduring this would be easy and I'm not sure where I would be mentally if I had not taken some sort of defensive action early so there is an element of easy for him to say in this but despite how "different" this event has been the fear is not different and I suspect the emotion that causes feel good rallies is not different either. Hopefully anyone hellbent on getting out can do so smartly but I am not part of the get out crowd.
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Weekend Roundup

A reader left a link to a long article from the Boston Globe about what a modern depression would look like. My first observation was that it reads a lot like Michael Panzner's book that I was probably the last person to read two years ago.

Amusingly it seemed less bleak than when I read most of the same stuff in Panzner's book two years ago because things have deteriorated so much since then. Foreclosures and unemployment are way up and the stock market and GDP are way down. Given that we are much closer to a depression in terms of what is actually happening on the ground it's like there is less ground between here and the scenario spelled out in the article and because of that it seemed less scary. I'm sure there is some sort of bias or coping mechanism that accounts for my reaction.

A couple of things I think the article missed is that people would migrate toward industries where there will be job growth which off the top would include healthcare workers, teachers and new government employees to administer the various stimulus and rescue plans.

I would also add that the idea of neighborhoods of overcrowded houses next to abandoned ones seems like more a of a micro phenomenon. Will the foreclosure rate make it to 15% of all mortgage borrowers? I have not seen any estimates that high. If, though, it does get that high that does not mean that all of those people will lose their jobs and for the ones that do, some portion (I would think a large portion) would seek out work that at a minimum left them under-employed. A couple, one of whom is a teacher, lets say, and the other a police officer, with a combined income of $80,000 that needs to go to foreclosure because of a reset of an ARM to a payment they can't afford can probably afford to go into some sort of rental at $1500 month as neither is likely to become unemployed.

That relatively rosy scenario is not an argument for no depression but more of an opinion (or hope) that it does not alter the social fabric of the country to the extent that many people fear. If we become a nation of collectively under-employed people then clearly far fewer people would prosper but it could also mean more people can stay put without turning their homes into multi generational compounds.

Next up is this from Jason Zweig about trying to take control of your financial situation, more specifically your investments. Most of the article sounds good to me but there is one thing I would add which is something not to do (the article is a list of things to do). Markets are down a lot. This triggers various sorts of emotions. Probably the worst thing to do after a 55% drop is to change your target allocation between equities and fixed income.

Even if you think October 2007 was 1929 making a radical overhaul to your target asset allocation now is a bad idea. At some point the market will come back, no matter how bullish or bearish you are it will come back, it came back from the 1930s. Maybe it takes two years (unlikely) or maybe it takes 20 years (also unlikely) but a switch today from 70 (stocks)/30 to 40/60 can only lengthen the time you need to get back. If you are young you have the time to give it to come back. If you are 100 years old now and think you won't be around in 20 years, less stock exposure won't help you out from here. The 70/30 number is just an example and I realize that 100 year old investor is unlikely to have more than 5% in stocks..

The above paragraph is not about any tactical defensive moves made thus far or that might be made from here. Someone can target 70% in equities and be underweight their target. The above paragraph is about people giving up which is different than tactical decisions.

If you have learned the hard way you had too much in stocks, from a numbers stand point you are better off waiting for it to at least come partially back before going from 70/30 to 40/60 or any numbers suitable for you. Not that doing so will be any easier for you but from a numbers standpoint...
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Sunday Morning Coffee

A reader asked what I think about the mark to market debate, bringing back the uptick rule and the government putting the screws to the ratings agencies.

From where I sit these issues are more solve the world's problems issues as opposed to trying to protect or grow assets (depending on where the cycle is at the moment).

Mark to Market; In response to this question long time reader Stephen Drone joked that we should let the banks put whatever value on them they want. To the extent that happens it is obviously a problem. However to the extent that it has artificially altered capital ratios and the like that too is a problem and in the real world there is some of both.

I could be easily convinced that artificially altered capital ratios were a part of the daisy chain the lead to so many failures and near failures. Not the cause of any of the bad behavior, dumb loans or greediness but a contributing factor further down the line to stocks going to zero.

Generally the idea of suspending mark to market seems right to me if they had done it ages ago. Now the genie is out of the bottle and it is not obvious to me that suspending mark to market now would solve as many problems as some people think--I'd love to be wrong about that one.

Uptick Rule; Before the uptick rule went away there were plenty of ways around it; ETFs, put options, other derivatives and odd lots. If you did not know odd lots did not require an up tick because odd lot trades do not get reported to the tape; I realize odd lots are not much use for a hedge fund but still worth mentioning. Further if someone bought 10,000 put options the market maker selling those puts could short stock (one way for the MM to hedge) without an uptick. Adam Warner just emailed me to say the part now struck out is incorrect. My bad. I have a specific memory of this but apparently I have mis-remembered (Roger Clemens reference).

I have never felt there was a lot of there there, so to speak, with the uptick. One thing I am not sure of, never having been much of a short seller, is what the process is for shorting an NYSE stock away from the NYSE and of course more volume gets done away from the exchange than the old days. To short a NASDAQ stock the bid had to be an uptick not the last trade. This differs from the NYSE where the last trade had to be an uptick and the order to sell short could not itself cause a down tick. But if the bid for IBM on an electronic market is an uptick then can short sellers just keeping selling regardless of the last trade?

Anywhoo back to the subject, plenty of very smart people articulate fine arguments for the uptick being reinstated but I just think there is less than meets the eye.

Ratings Agencies; If you believe they are scumbags with no integrity who can be bought then they have lost all credibility with you. Is there anything then that the government could do to restore your faith in them (assuming you ever had faith)?

Is what they did with AAA ratings on pools of crappy loans really as despicable as some claim? Regardless of your opinion it happened and at the very least blew up or otherwise meaningfully impaired many pools of capital. What good does it do to fix them now?

Of course this need to be addressed but it in no way that I can think of contributes to whatever finally solves this crisis. If that rings true then it probably won't get the right kind of attention for a while.

The picture is on the road to the beach at Waipi'o Valley. The road down from the top is the real steep road from the other day and then it is the flat road you see today out to the water.
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The Big Picture For The Week Of March 8, 2009

Yesterday we had to do an errand in Kona at Costco. This was my third time at this Costco and it was far busier than other times (it took a while to find parking even at the outer edges) and yes the cash register lines were all very deep.

We then went up to Hawi (pronounced Ha-vee) for lunch and the little place where we ate (at 3pm mind you) was packed with people coming and going.

The plane from Phoenix to Honolulu was packed as it almost always is (for people who ask; Hawaiian has has the same schedule of one flight from Phoenix every day and one flight back). The flight attendant said most of the flights are still full although one thing she said that was odd is that they have stopped showing full-length feature films between the mainland and Hawaii because the rights to the films are too expensive.

Obviously these observations are not scientific but they are interesting. I mentioned something along these lines the other day and the comments were a mix of its not that bad and it looks pretty bad. I've noticed a few things here and in Arizona like empty store fronts and less real estate activity but nothing like the sense of despondency like I imagine there must be in places like the rust belt.

The jobs numbers have stunk for a long time, output numbers stink too and the stock market has clearly discounted in a crappy economy. There is no doubt about that regardless of where anyone thinks stocks will be in three months, the stock market is telling things are lousy but the data doesn't necessarily have to jibe with the story on the ground everywhere (some places yes but not everywhere). In that context I feel better that socially we are not headed toward a repeat of the 1930s. The data for now seems unlikely to get as bad as the 1930's (I don't read too much analysis that calls for GDP to contract by more than 10% or unemployment anywhere near great depression levels) even if a lot of folks are worried that stocks are headed toward an 80% decline.

If we somehow actually go into a depression I do not think it will be as bad as our visions of the previous depression. I wonder whether most folks actually have as good a sense for what things were like as they think they do. In the 19th century there were several depressions but given how little they get discussed I am assuming they were not as bad as the 1930s (I only know that they happened, not any particulars; feel free to leave a comment if you know about them).

Of course I might be wrong about this and I'm sure someone will tell me why I will be wrong (popular theme lately) but I don't think this will really hurt as many people as the numbers would imply. I would submit that given the S&P 500 is 46% below where it was ten years ago and at 1996 levels we might already be in a depression of sorts. If so, then we arealready many years in and things are not anywhere close to the 1930s.

The picture is on the drive down from Hawi to Waimea.
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Holy Crud! Part Deux

Exactly two weeks ago I posted these same three stocks in a post called Holy Crud! Back then GE was at $10.06, BAC $3.93 and Citi at $2.51.

I don't follow GE very closely but the looming downgrade, should it happen, will cause its costs to go up. The more notches in the downgrade the more expense in funding its operations. There also exists the possibility of an $8 billion CDS problem. According to the FT the company has $36 billion in cash and its recent dividend cut should save $9 billion per year. The company has always had a lot of moving parts, I have no idea what will happen here but avoiding this sort of extreme complexity is not a bad idea.

What is there to say about BAC? Well probably a lot I suppose. I disclosed selling the stock in the face of the merger. For the first few points down it was a smart sale then at some point on the way to $3 it became a lucky sale (actually right after I sold, they banned short selling and the stock went up a lot before going down).

Two appearances ago on CNBC I said that Citi would not go to zero as the bailout/investment by the government would take that off the table. Why would they throw billions at the problem only to then let it fail? Either my conclusion was wrong or someone forgot to tell the market.

While were at it GM is below $2, the market cap is just over $1 billion. It would seem there will be a lot more tears for people that rely on that company.

While I believe the key to capturing a turn around in your portfolio at some point will be sector and country selection (as opposed to SPY and EFA) the manner in which we access "the right" countries and sectors could pose problems. Even if a bottom in the market is coming soon there will be more horror stories like the stocks mentioned above. There are certain country and sector funds that are heavy in a couple of stocks. So it may be possible to pick the correct sector but be adversely affected by a fund's composition.

As an example the iShares Telecom Fund (IYZ) has 21% in AT&T (T). If T drops 90% (unlikely but look at the names above) then IYZ will get hurt even if the rest of telecom does well. If you are going to use ETFs you will need to look under the hood and for some sort of opinion on the construction of those ETFs, so more work not less.
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Waipi'o Psychology

Joellyn says no picture can capture how steep this is.
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Tool Box

In recognition of the possibility that we need to look to more outside the box investments I thought I would mention a couple of things I follow and maybe you can share a couple of things along these lines that you follow. Maybe we can have a collective expansion of horizons.

The New Zealand dollar is now below US $0.50 and based on it's deficits galore, likelihood that the RBNZ has more work to do and a looming S&P downgrade the kiwi will probably go a little lower in the next few months.

In November 2000 the kiwi spent a few days below US $0.40 then doubled to $0.80 last March, albeit with a couple of hiccups along the way.

At some point the kiwi will go on the upswing again and someone will make a lot of money holding the kiwi. New Zealand is kind of an easy country to follow because there are very few moving parts compared to the US. It is a proxy for risk, a proxy for commodities (even though it produces more timber and agriculture than ore and the like) and NZ is growing trade with China. WisdomTree has a kiwi dollar ETF with ticker BNZ that makes access easy. To be clear I do not own BNZ, don't know if I will and think there is more downside to come.

The chart compares iPath Platinum (PGM) with SPDR Gold Trust (GLD), which is a client holding. It shows PGM dramatically underperforming GLD last fall and over the last few months there has been a zig zag relationship.

You can usually find a current article making the case for platinum over gold. Sometimes those articles are correct and sometimes not. Some folks will have a knack for success with kind of pair trade or if going short is not your thing (either for comfort or account restrictions) then maybe swapping from one to the other for precious metals insurance.

I believe in PM insurance, realize that at times platinum will be the more effective insurance but have yet to sort out the extent to which I would be comfortable doing this.

Last one from me today is the Airshares EU Carbon Allowances ETF (ASO). It listed two months ago at $25, fell as low as $12.17 at one point and closed yesterday at $17.48. ASO seems to be a proxy for economic expectations. If the market sees a slowdown (obviously it does and that is exactly what has been going on for the last few months) then ASO should be expected to go down. At some point the market will start to see expansion/recovery on the horizon and ASO would likely turn up at that point.

A proxy for trading the Baltic shipping indexes would do something very similar in terms of tracking expectations. The BDI had a nice bounce from early December to mid February but I should note that there are some who believe the BDI is not a good measure of expectations for the economy. For now there is no product on it and I would suggest you sort out for yourself BDI's utility in this regard.

You should also sort out for yourself whether this stands up for ASO or not. I think there is something to it but am still trying to sort it out. Broad-based equity indexes may now be skewed, (this is my opinion) because of the sector distortions that have occurred during this decade (first tech, then financials), in such a way that a bull market could start but not be reflected in the broad based indexes (a theory of mine that might be worth exploring in a little more detail on another day).

From a bigger picture standpoint, there are a lot of ideas like this out there. It only takes one or two to meaningfully help a portfolio.
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Maalox Market

Thank goodness February is over, I couldn't have taken anymore (a little levity).

I will reference for the second time a comment I made a week or so ago about the psychological impact of another big move down being worse than the financial impact.

The market has been doing some strange things in terms of how fast it has gone down and at the same time how much it has gone down (22% YTD, that's only 40 trading days). It is strange that the selling has not taken any sort of break and that it has now been a long time without some sort of feel good rally.

Regardless of whether you are a Roubinian or a Kudlowite the market action is odd. The biggest bears out there could have their thesis play out in a tape dotted here and there with sucker's rallies but the action since about one week into the year has been unrelenting in its direction.

A huge portion of the writing I have done starting in 2004 has been about how to cope with markets like this when fear is at its peak (or close to it). The idea behind using a breach below the 200 DMA is a trigger point for defense is to avoid some of the emotion that bear markets eventually bring out. The idea behind talking about this bear, the next one and the one after is to drive home the point that bear markets are a normal part of the process.

Way back in 2004 I wrote about having a defensive strategy devised then when there was no emotion to cloud judgment. By preparing a strategy and by preparing mentally you have lessened the portfolio damage and the emotional angst.

A reader on Seeking Alpha noted that in his 30 years in the markets people always think the world is ending when the markets decline a lot. I can tell you first hand for most of that 30 years that the reader is correct. Eventually the majority gives into fear and do the wrong thing. The world is not ending. If you have a lot of cash built up your account will not go to zero, in fact odds are very few stocks will go to zero (has there even been 20 out of however many thousands of stocks traded?) and no ETFs will go to zero.

I may turn out to be wrong about the S&P 500 dropping to the 600 level or lower (I don't think it will) but if that does happen, the psychological damage will be worse than the financial damage.
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Good Times?

A reader who works in the industry emailed me over the weekend and commented that he believes "the future for investing will be much different than the past."

I generally follow the line of thinking. I have been writing about the evolution of investing from the start of this site, exploring the merits (or lack thereof) of new types of asset classes and have implemented a couple of these types of investments in client accounts.

That the investment world is changing is something I can buy into but it is difficult for me to wrap my head around the idea that a bell rang in late 2007 marking the end of equity investing as we know it. My expectation was that over a longer period of time equities would become less compelling for an extended period consistent with my past comments about equities averaging closer to 5% over time not 10%. Further I would have expected such a transition to be much quieter than the fast 50% decline for the broader averages.

Reading that a shift away from equities should theoretically be slower and quieter you might reply that the shift is not over the last 15 months but the last ten years. That might be correct of course but cutting in half as we did from 2000-2002 was not unprecedented. The market does that every few decades but never twice in a decade (that I am aware of).

While the second 50% decline this decade works against my thesis I had one thought that supports equities not being dead. As the current bear market started in 2007 market participants had a certain knowledge of history and truisms of how markets work and many people in the market in 2007 were also in the market in 2000. However there were far fewer people in the market in 2000 than were in the market in 1973. Point being that if you have survived a 50% decline previously you are less likely to be scared out when the next one comes along.

The fear created in 2002 was new for enough people that it allowed for emotion to peak and stocks to bottom. The fear created by the second 50% decline is less than the first one which prevents emotion from peaking at the same level as before so it prevents stocks from bottoming at the same level. Put differently, perhaps we need a lower level on SPX to create the same fear that created a bottom in November 2002.

If this is true then it may not be the end of equities just a larger decline to create the bottom. FWIW I do not believe it is the end of equities, I believe returns will be lower than average which is not the same as the end of them altogether. To be clear about one thing this post is an exploration of market psychology not a discussion of the current fundamentals.
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