Welcome to October. Trick or Treat?

10 Friday Oct 2014

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We are finally getting some overdue weakness in the stock market. I say overdue, because we haven’t had a 10% correction since 2011.

Still, the S&P 500 at yesterday’s close of 1928.21 is only down 4.5% from its 52-week high of 2019.26. While no one knows what the future holds, some context can be helpful when pondering what may be in store for your portfolio.

Where We Stand

The bull market is five and a half years old and the S&P 500 has roughly tripled over that time. Some say it has all been due to the Fed, but earnings have also been on a tear since the bottom in March of 2009.

I don’t see signs of a recession on the near-term horizon for the economy. This would suggest that downside should be limited. That said, we can easily expect a 10-12% correction sometime soon (this may be it).

And with the age of the bull market, international economic weakness, the strong dollar, and the end of quantitative easing, a 20-30% cyclical bear market can’t be ruled out. But a 50% wipeout, while not being beyond the realm of possibility, would seem to be quite unlikely.

Jeff Saut, the chief strategist for Raymond James, sees a correction soon, but thinks we are in a secular (long-term) bull market like 1982-2000. If so, selloffs are long-term buying opportunities.

Take The Long View

If you are invested in equities, you have to take the long view. Have a good plan and an asset allocation that is appropriate for your goals and risk tolerance, but know that the price of good long-term returns in stocks is occasional near-term unpleasantness.

Unless the fundamentals of the businesses you are invested in have deteriorated, there is no reason to sell, and good reason to consider buying on price weakness.

“Real investment risk is measured not by the percent that a stock may decline in price in relation to the general market in a given period, but by the danger of a loss of quality and earnings power through economic changes or deterioration in management.” — Benjamin Graham

Retirees Need A Portfolio That Will Allow Them To Sleep At Night

If you are fully invested and a retiree or near-retiree, the prospect of a selloff is not very pleasant. Asset allocation and risk management are key. You need to create a portfolio you can live with in good times and bad without panic selling at the bottom.

“Ultimately, nothing should be more important to investors than the ability to sleep soundly at night.” — Seth Klarman

For Young People, A Selloff Is Good News

Jason Zweig quipped that he’d like to start the Benjamin Graham Financial Network, which would report selloffs as good news.

Particularly if you are a young person just starting out, downward volatility is your friend because you can buy cheap, and you will be shoveling money in and compounding your returns for decades to come.

Your emotions may suggest differently, but a selloff is good news for you as long as you have the fortitude to keep buying when stocks are going down. Remember that money you will need or want in the next 5 years has no business being in the stock market.

“If you are shopping for common stocks, choose them the way you would buy groceries, not the way you would buy perfume.” — Benjamin Graham

Emotion Is The Investor’s Biggest Enemy

Emotion is the investor’s chief enemy, because it makes us want to buy after stocks have gone up, and sell during and after a selloff. Leaning against your emotions is one of the most important parts of being a successful investor.

If you can’t do it yourself, a good adviser can be worth their weight in gold if they can talk you down off of the ledge and keep you from selling into a panic.

The time to prepare for a selloff is when the market is charging higher. The emotions are too punishing to think rationally to come up with a plan during a selloff.

“The real ‘perfect’ portfolio is whatever approach allows you to stick with your investment plan without completely abandoning your strategy at the worst possible times.” — Ben Carlson

Season of the Witch

October has a reputation as the month of crashes, and several famous ones have come during the month — 1929, 1987, 2008. However, it has better average performance than September, though this doesn’t help much if this year is one of the outliers.

But October is also the end of the traditionally weak 6 months beginning in May, and many times it is when a near-term bottom is made. And the upcoming 3rd year of the Presidential Cycle is also usually quite strong.

The Long Term Looks Bright

None of these positive seasonal tendencies are guarantees, but doom and gloom predictions should be ignored.

The advances ahead in technology in general, and biotechnology in particular, will likely be amazing. And as Jeff Saut has pointed out, the American Energy Revolution is like putting Saudi Arabia on top of America’s industrial might. These factors all seem very bullish long term.

Never lose faith in the ingenuity of the American people. This is what you are betting on in the stock market in the long term.

Keep one eye on valuation and another on risk management, and you will be fine. Make a good plan and stick with it through thick and thin.

The Notorious AIG

08 Wednesday Oct 2014

Posted by JC in Uncategorized

≈ 4 Comments

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AIG, Bailout, Finance, Financial Crisis

Just as the Great Financial Crisis has begun to fade a bit from consciousness, one of its main perpetrators returns to remind us all why we can’t let our guard down vis-à-vis Big Finance.

Hank Greenberg, the former CEO of AIG, has filed suit to force the government to repay stockholders who he claims were short-changed when the government bailed out AIG to save the financial system. He claims this despite the facts that his stock would have been worth nothing had the government let the company fail, and the board of directors approved the bailout.

This is incredible, and yet it should almost be expected, since the one unlimited resource on Wall Street is gall. But, perversely, this is a great reminder of why the financial sector can’t be trusted to police itself and must be regulated stringently to avoid another crisis.

AIG Had Us Staring Into the Abyss

Just to review, AIG was the linchpin that would have sunk the financial system and the economy without the government coming in and bailing them out after the failure of Lehman Brothers. This was so because AIG had issued a gigantic amount of Credit Default Swaps, which are essentially unreserved-for insurance, on a massive share of the “innovative,” garbage-like, mortgage-debt securities that were ready to go bad at the popping of the real estate bubble — Collateralized Debt Obligations, CDO Squared, and the like.

All of the big Wall Street firms had bought this insurance from AIG that allowed them to make believe their balance sheets weren’t built on quicksand. The failure of Lehman Brothers meant big insurance payouts were due to the holders of the CDS, and AIG had nowhere near the resources to pay them off, because they had no reserves against the insurance.

So if the government hadn’t stepped in, not only AIG but the whole financial system would have fallen like a house of cards, and the economy with it. So the government had no choice but to bail them out as the lesser of two evils. The alternative would have been human suffering on the scale of the 1930’s.

“Idealism is fine, but as it approaches reality, the costs become prohibitive.”
— William F. Buckley, Jr.

Heads I Win, Tails You Lose

This is a helpful reminder of the fact that Wall Street is not capitalist. In capitalism, you risk your own money for the chance at gain if you succeed or the certainty of loss if you fail.

Wall Street operates in a corporate-socialist milieu that has as its guiding principle, heads I win and tails you lose. In other words, the profits from their reckless gambling in the good times goes into their pockets, but when the excrement hits the fan and everything falls apart the government and the taxpayer have to step in to save the system.

This asymmetry of risk and reward is called moral hazard. If someone pays no price for recklessness, they will become more reckless. But Big Finance plays this risky game with the lives and livelihoods of each and every citizen. This is why free-market, laissez-faire economics doesn’t work with the financial system.

This is one area where I think most national Republican politicians are dead wrong in pushing back against regulating Wall Street. Strict regulation is needed. But they need to regulate the Hell out of the Big Banks, not the community banks that are getting put out of business by the compliance costs of Dodd-Frank when they had nothing to do with causing the crisis in the first place.

Moral Hazard, Incorporated

In finance, it is said that the guy with the lowest standards sets the market. That is why Big Finance can’t be left to regulate itself. Either that, or the bill for the next crisis may dwarf the government’s ability to pay, and then we will all be sunk.

“Instruct regulators to look for the newest fad in the [banking] industry and examine it with great care. The next mistake will be a new way to make a loan that will not be repaid.”
— William Seidman, “Full Faith and Credit”, 1993

Zone of Competence

~ Dollars, Sense, and Probabilities.

Monthly Archives: October 2014

Welcome to October. Trick or Treat?

The Notorious AIG