Tuesday, September 30, 2008

How to play this crisis--Do nothing?

What should an investor do after a day like Monday, when the Dow, S&P, and Nasdaq all plummeted about 8% following Congress's "no" vote on the $700 billion bailout plan? Some say: "I wouldn't recommend anyone sell after a day like Monday but wouldn't be in a rush to buy stocks either." (See article by Aaron Task and Henry Blodget at Tech Ticker)

So, neither sell (if you own stocks), nor buy (if you have cash to buy). In other words, do nothing.

Does this make sense?

Think about the various market views one might have:

Bullish: If you "know" for sure that the stock market will rise from here, obviously you should be invested 100% in stocks, and presumably you would recommend that others buy stocks too (since "knock-on" effects help to fulfill your prophesy);

Bearish: Similarly, if you "know" the market will fall, you'll want to be sidelined, holding all cash and no stocks, and you would recommend that others (at least anyone you care about) sell out too to avoid additional losses;

Neutral: Or, if you just happen to "know" that the market will trade in a tight band, essentially unchanged, you would tell others that it really doesn't matter what they do, since holding stock in your portfolio or not will land you at the same place as cash if the market doesn't move.

In this context, the recommendation to "do nothing" appears to be an implicit statement that the stock market will trade sideways, meaning that, whether you currently hold stocks or hold cash, making no changes to your portfolio (i.e., neither buying nor selling) will not leave you at any disadvantage relative to someone who takes action and switches strategy.

A glance over at Intrade for a popular prediction about where the stock market is headed shows a 50% chance that at year-end (close of trading in December) the Dow will be at or above 11,000, in the opinion of those willing to wager bets on their views. Seeing that the Dow is now (1:55 p.m., New York time, Tuesday, September 30) at 10,700, the benchmark level of 11,000 on December 31 is essentially unchanged from today.

With the financial media being what it is, this match between Tech Ticker and consensus opinion should be no surprise. . . .

However, I also note that anyone holding cash who chose not to deploy it after yesterday's fall is missing today's rally, which appears to be strengthening as I write. At least so far today, the right decision has been to be 100% long this market. So much for doing nothing . . . unless you are already fully invested.

Tuesday, September 23, 2008

Will we ever get out of this financial mess we're in?

I look out my office window and see a suburban scene pretty much as usual--a few parked cars, an occasional pedestrian, a tree-lined street, a bird flies by. . . . Yet the headlines say we are in the midst of the worst financial crisis since the Great Depression. Fannie Mae and Freddie Mac are bailed out by the government, Bear Stearns is forced into a government-orchestrated sale to JPMorgan, Lehman goes bankrupt, Merrill is getting bought out by B of A, AIG is fighting to avoid becoming 80% government-owned, Morgan Stanley takes a 10% to 20% investment from Mitsubishi UFJ, WaMu will likely get bought out, Citi is surviving but staggers like a wounded elephant with arrows in its back. . . . And many pundits say we have not yet reached the bottom.

What's the root cause of this financial mess? Some point to the falling housing market, particularly in California and Florida, where millions of homeowners are struggling and many thousands are defaulting on their monthly mortgage payments. Others say it's debt in general, not just mortgages but also car loans, credit cards and the like, i.e., consumer debt as a whole. Yes, it's easy to understand how the debt burden in our consumption-oriented society with a savings rate either slightly negative or close to zero just "had to" catch up with us sooner or later.

There's a thought-provoking video entitled "Money as Debt," pedagogically praiseworthy if not completely accurate in all detail, which explains how money itself can be viewed as a form of debt that is created by our financial system. If you can spare 47 minutes of your day to watch the video, here's the link. The video's thesis is that our modern system of money is intrinsically unsustainable, since money's very existence depends on the continual creation of more and more money (or debt, depending on your perspective) to pay the interest (in addition to principal) owed by all us borrowers who have drawn down loans from banks and other financial institutions. The picture here is that of an ever-increasing pile of debt, an exponentially growing mountain of indebtedness that inevitably leads to the outcome we all fear like the plague--a collapse of our entire monetary system and its consumer-capitalist lifestyle that we just "can't live without." Right . . . try to imagine a world without WaMu, Citi, JPMorgan, Goldman, B of A . . . maybe even no Walmart, Costco, Nordstrom. . . . Pretty hard to visualize, eh?

A friend wrote to me the other day, saying that he has heard that one way to fix the U.S.'s financial problems is to "inflate the dollar." While economic solutions are never as easy to implement as they are to state, I think this view is essentially correct. This morning, as Bernanke and Paulson adamantly urge Congress to float their $700 billion bank rescue plan (that's $2,300 for every American), what we are seeing is an attempt to feed the credit-hungry monster that we have created over the past century. The proposal is to use $700 billion to buy "bad" (illiquid) loans from the many embattled banks, thereby replenishing their books with new (liquid) money that they can, in turn, lend to struggling consumers who are in dire need of more loans to make principal and interest payments on their existing loans--hence, stabilizing the housing market and stemming the breakdown of the financial system before it truly spirals out of control.

And where does this $700 billion come from? Well, that's why Congress is being asked to approve a higher statutory limit on federal debt, to the tune of some $11.3 trillion. With a higher debt ceiling, the government can borrow the $700 billion from investors through the capital markets (i.e., foreign governments and institutions, since that's who buys government bonds these days). The net result will be a "re-leveraging" of our financial system here in the U.S., which will likely, over time, lead to higher interest rates (to persuade foreigners to continue to lend), a need for more borrowing to pay off this principal and interest, the creation of more money. . . . Sound familiar?

From an investment point of view, I believe stock market direction in the short run is anyone's guess, as the dynamics (I first mistyped "dymanics" here, which, come to think of it, better captures the spirit of today's volatile, "manic" market!) of the current situation change from day to day, if not hour to hour. Longer term (i.e., over the next five to ten years), I believe that the equity markets (both stocks and real estate) will stabilize, rebound and even see new highs. Both economically and politically, "the powers that be"--meaning the billionaires who own stock and real estate, the politicians who wish to be re-elected, and the business executives who want to keep their jobs--will do whatever they can to protect their own self-interest and, in so doing, keep confined to its ever-expanding cage that awakening credit monster with a voracious appetite for more and more debt.

Drawing an analogy of our 232-year old U.S. economy to Rome some two thousand years ago:
". . . Essentially it was an aristocracy, in which old and rich families, through ability and privilege, held office for hundreds of years, and gave to Roman policy a tenacious continuity that was the secret of its accomplishments.

"But it had its faults. It was a clumsy confusion of checks and balances in which nearly every command could in time of peace be nullified by an equal and opposite command. . . . What astonishes us is that such a government could last so long (508 to 49 B.C.) and achieve so much. . . . Devotion to the state marked the zenith of the Republic, as unparalleled political corruption marked its fall. Rome remained great as long as she had enemies who forced her to unity, vision and heroism. When she had overcome them all she flourished for a moment and then began to die." (Will Durant, The Story of Civilization: Part III, Caesar and Christ, pp. 34-35)

As the historical record indicates, the expansive Roman Empire (146 B.C. to 192 A.D.) followed the earlier Republic (508 B.C. to 30 B.C.) stage, and the fall of Rome "was not an event but a process spread over 300 years." (Durant, p. 665) In a similar vein, I would venture to say that the U.S. economy and the larger global economy, however fragile they may now appear, most likely will see more prosperous years ahead. Though Wall Street's headline events of these past few months may be eye-popping, our debt-laden system, despite its flaws, will most likely bring lots of volatility (both upside and downside) but will not collapse anytime soon.

In short, if any end is near, it's probably the end of the financial mess we're in, rather than the end of economic growth and the corresponding secular rise of the market.