Stock Market Cycles: Survive Them and Prosper
It’s no accident that most people can name the big market bottoms – it’s because they are relatively infrequent. The best investors, Chris Mayer explains, buy value when it’s offered and don’t worry about timing the market or fretting about recessions.
I love the process of investing – all the thinking about the craft itself and the fun of rummaging around looking for interesting stuff to buy. So naturally, when I get a chance to hear successful investors chat, I go out of my way to grab a seat. You never stop learning.
I headed up to Manhattan recently with Dan Amoss, who writes the new (and red-hot) Strategic Short Report. We met in Baltimore and caught a train north to attend the 2008 Columbia Investment Management Conference. There, an all-star cast of successful investors assembled to speak about this crazy craft we all find irresistible – and to offer some ideas.
Richard Pzena’s opening talk was the most interesting to me. In part, because what he had to say was timely, yet full of timeless wisdom. His title: "Surviving the Cycles of Investing."
Good topic, considering the nasty spill the market took to open 2008. And with the cloud of recession thick in the air, investors seem awfully full of worry. Pzena had some soothing words.
Pzena says there were only eight years in the last 40 when you would’ve been down 20% using a simple value approach. (For purposes of his discussion, he used a simple value strategy of buying stocks only in the lowest quartile of the market ranked by price to book. But the point applies to all us cost-conscious investors.) We just suffered through one of them – with the S&P 500 and Dow Jones industrial average dropping 20% from top to trough.
One obvious conclusion from looking at the data, if you are a value-minded sort like me, is to shrug off the bad times and say, "Who cares?" It’s no accident that most people can name the big bottoms (1974, 1982, 1990…). It’s because they are relatively infrequent. Plus, the long-term return on value stocks over the full 40 years more than made up for them.
"The problem is," as Pzena says, "when you’re losing 20%, it doesn’t feel very good." You start to question what you’re doing. You start to wonder, Can I avoid those 20% down periods? Should I avoid them?"
To the first, Pzena rolls out the shopworn, but tested wisdom that trying to predict exactly when these downdrafts will happen is impossible. And selling after the market has already taken its tumble is a sure loser.
Therefore, "riding through them is the smarter thing to do," he advises. "The quest to get the timing right is what trips up most investors," Pzena says. The best investors buy value when it’s offered and don’t worry about timing the market or fretting about recessions.
Many investors think that with a recession looming, or already here, it may be best to sit on the sidelines. One problem with this is that economic health is extremely difficult to gauge. It’s not as if you can slap on a pair of latex gloves and say to the economy, "Turn left and cough." It’s possible we won’t know we were in a recession for sure until it’s over.
But even so, recessions tend to be good times for investors who buy value. Pzena had examples. From January-December 1969, we had a momentum market. A momentum market is one in which people focus on getting the next piece of information. Quarterly earnings reports and recent price action dominate. This kind of market can be difficult for value guys, who think longer term.
However, Pzena points out that a recession began in December 1969 and lasted through January 1971. Stocks flipped to a value market from January 1971yyyAugust 1977. The timing of that flip was coincident with the beginning of a recession. The same holds true for all recession cycles of the last 40 years, according to Pzena.
How do you explain it? Pzena asks: "As people worry about a recession, what do they do? They put their money in what’s working." That means momentum stocks, or stocks that have gone up. They worry about what the recession will impact. This is where we are now.
The thing is, as Pzena discussed, recessions bode well for investors looking to pick up bargains. As you get into the recession, though, people start to think about valuation again. Momentum stuff starts to not make sense.
Are we in a recession now? Pzena didn’t hesitate to make a guess. "Anecdotally, yes," opined Pzena. "Toward the end of 2007, we had, at least, a major slowdown." The market is, once again, offering attractive bargains.
Pzena points to price-to-book indicators. Right before 2007, there was a narrow gap between the lowest quartile by price to book and the S&P 500. Meaning, the cheapest price-to-book stocks were trading at a small discount compared with the rest of the market. Now that gap has reversed. The gap is now wide, Pzena says.
So parts of the market look attractive again. But what about those ugly headlines, you say? "This is why value works," Pzena says. "Because when you see your list, you want to throw up." It’s what gets you the pricing you want.
The savvy group at the conference was excited about the opportunities the market has given them. They are not alone. Several great funds long closed to investors are now open again for new investors. These include the Tweedy Browne Global Value Fund, the Longleaf Partners Fund, the First Eagle Global and Overseas funds, the Third Avenue International Value Fund and the First Pacific Crescent Fund. They’re open because they have more ideas than they have money. They want to buy.
That’s a useful list if you’re looking for some excellent funds. I’d give these funds a look, because they don’t tend to stay open for long. The opening of these funds, captained by investors with long track records of success, is also an indicator that the smart money is buying.
for The Daily Reckoning
March 19, 2008
Chris’ newsletter, Capital & Crisis, excels in taking a downturn in the market and turning it into a major opportunity for profit.
Chris is a veteran of the banking industry, specifically in the area of corporate lending. A financial writer since 1998, Mr. Mayer’s essays have appeared in a wide variety of publications, from the Mises.org Daily Article series to here in The Daily Reckoning. He is the editor of Mayer’s Special Situations and Capital & Crisis – formerly the Fleet Street Letter.
Chris also recently wrote a book: Invest Like a Dealmaker: Secrets from a Former Banking Insider.
Our colleague in South America, Horacio Pozzo, reminded us of Jesse Livermore’s famous remark…and went on to site a study of goalies in soccer games. Some tend to move to the right, when an attacker presents himself. Others tend to move to the left. But the ones with the greatest success stay put, squarely in the center.
In today’s markets, Horacio suggests, doing nothing may be the best move.
Inactivity comes easily to us. We almost never regret doing nothing. It’s the times we were too slack to do nothing that got us into trouble.
But this is a family publication, so we will pass over those events…and focus on the financial world.
Yesterday, the Fed took more action – cutting its key rate another 75 basis points to 2.25%. See how easy central banking is? You read the headlines. If they’re negative or scary, you cut rates. If they’re positive…or inflationary…you increase them.
"I think the Fed was pretty shrewd," says colleague Ben Traynor here in London. "They were widely expected to cut rates by a full point. It makes 75 basis points look conservative – as if there was really nothing to panic over. And it leaves them with more room to cut in the future."
Yes, dear reader, there are still 225 basis points from here to zero. In the ’90s, the Bank of Japan, of course, used up all its basis points. Still, the Japanese economy sank…and sank some more. Even today, an investor who bought Japanese stocks in January 1990 is still looking at a loss of more than two-thirds of his money – 18 years later.
But investors yesterday ignored the Japanese example and gathered up U.S. stocks with both hands. The Dow rallied 420 points.
"Buy the rumor, sell the news," is another old Wall Street saying. Since we’re sticking with our Trade of the Decade – buy gold on dips…sell stocks on rallies – the news of this latest Fed intervention gives us another great opportunity to dump shares. Don’t miss it.
On the other side of the trade, the price of gold slipped yesterday…but not enough to qualify as a genuine dip. Commodities, generally, are getting whacked. But gold is a special case. It’s the ultimate money. People buy it when they suspect that there’s something with the other kind of money…the kind people use when they go to the grocery store.
What exactly is wrong with the dollar? Ah, dear reader, that’s a long, long story. Will the dollar go up or down? Ah, dear reader…we wish we knew.
We’re betting against the dollar – over the long run – for the many reasons we’ve discussed in these Daily Reckonings for the last eight years. But in the short run, anything can happen. In fact, we think it is time for a rally in the dollar…and a fall in the price of gold. We have no econometric study to back us up…and no sophisticated math that proves it. It’s just an intuition…and a worry.
The supply theory of money is simple enough. The more dollars you have, the less each one will buy. So, the question for a dollar watcher is: how many dollars are there? But there is no simple answer. Imagine we have an account at a brokerage…and we invest it in gold. Now, imagine that the price of gold doubles. Suddenly, we have twice as many dollars in my account, right? But where did they come from?
And now, we can sell the gold and buy something. We can, for example, have our brokerage wire the money to someone else’s account. That person, then, could transfer title to a house, for example. And, then that person might wire the money to yet another account where it is invested in a derivative contract, which in turn doubles in price, so that now he has twice as much money again. Where did that money come from? And all of this has happened without anyone actually touching a single dollar bill.
Now, imagine that there is a market crash…suddenly, all that money that came so easily goes just as easily. It disappears. Where did it go? Into the ether!
Right now, a lot of money is disappearing. House prices are falling. Stocks all over the world are going down. Many financial assets – specialized derivative contracts and junk bonds – are getting hammered. The amounts of "implied" wealth lost are enormous. Worldwide stock market capitalization may be down about $5 trillion. Residential housing in the United States has lost about $2 trillion.
In addition to the quantity of money, there is also the velocity of it. If we leave a dollar in a desk drawer, it may be part of the ‘money supply,’ but it is an inactive part. Prices are said to be the result of demand chasing supply. But the dollar in the desk doesn’t chase anything. So it doesn’t drive up prices.
When investors and lenders become fearful, the velocity of money tends to go down. People leave money in their safes…in their wallets…and in their accounts. They are reluctant to let it out for fear that it won’t come back. This, too, further diminishes the number of dollars chasing goods and services (not to mention financial assets).
As we have opined many times, we are witnessing a great battle – between the forces of inflation and the forces of deflation. In the last few weeks, it looked as though inflation was going to be the clear winner – with gold and oil hitting new milestones. But the battle is far from over. And despite the feds’ attempts to fix the fight – with rate cuts, bailouts and Bernanke’s helicopters waiting on the tarmac – inflation is no sure bet.
You are well aware, dear reader, there are no sure bets in the wacky world in finance…but when it comes to our favorite yellow metal, colleague Ed Bugos assures us: You ain’t seen nothing yet.
As the latest addition to the Agora Financial family with the newly launched Gold & Options Trader, you’d think Ed would want to lay low for a while…get a taste for his surroundings. But no – he’s hopped right into the mix with this claim: gold should soon hit $2,138 per ounce. And Ed’s got the data to back up that bold assertion. We think he’s going to fit in here just fine.
Check out his special report that lists the 9 reasons gold can only go up from here – and if you act fast, you can get into Gold & Options Trader before we raise the price. Get all the details here…
*** Poor Abby Cohen…she’s left her post at Goldman.
Goldman (NYSE:GS) itself is not doing too badly. Its earnings were down only 53% – less of a drop than expected. Lehmann Bros. (NYSE:LEH) too turned in a surprisingly good report – with a 57% decline in earnings.
*** We had a conversation yesterday with a source, very close to the Bear Stearns situation.
"What went wrong?" we wanted to know. "How could this group of very smart accountants, lawyers, and investment pros have been so wrong about what they had in their own portfolios?"
There was something fishy about the whole story. One day, they think they have a stock worth $30…a few hours later, they sell it for $2 – making the whole company worth less than a quarter of the value of their headquarters building. If they had thought it wasn’t worth $30, they would have unloaded it then. Instead, they held until forced to turn it over for practically nothing.
"Well, they didn’t really know. And they still don’t really know," said our source. "They have no reliable way of knowing what their ‘assets’ are worth. They’re not marked to market; they’re marked to whatever fantasy they have in their heads at the moment. When the fantasy was positive, the assets were worth something. When the fantasy turned into a nightmare, they panicked and wanted to get rid of them in the worst possible way.
"And the really scary thing is that the other financial institutions are in much the same situation. They don’t really know what they have…or what it is worth. There are almost certainly some more horror stories that will be coming out.
"Of course, this is good news to me. I’m in the business of buying assets cheap. Until now, the positive fantasies got in the way. There was too much silly money around ready to pay silly prices. Now, the silly money is disappearing. I’m beginning to see bargains in the financial sector. But I’m not going to buy yet. I’ll wait until the cupboards and closets have been cleaned out…and the nightmares have come and gone. I reckon there will be some very good deals in the financial sector a year from now."
*** Treasury bonds are going up in price as investors seek a haven against risk. But over the long run, Treasuries may turn out to be the very worst place for your money.
Now, inflation is running around 4% (officially)…about the same thing as you get from government’s bonds and notes. If inflation remains at this level, a lender will get back from the government about what he put in – maybe a little less. It seems more likely to us that inflation rates will go up…if not sooner, later.
Back when we were in grammar school, the U.S. Treasury had a program in which it sold savings bonds through the school system. We don’t remember how it worked, exactly, but we recall being urged to buy them. School officials thought it was a good way to encourage thrift and savings among the young. Our parents thought it was a safe way to put aside a little bit of money for our education.
By the ’60s, however, the little tots were being wiped out. And by the ’70s, we called bonds "certificates of guaranteed confiscation," when inflation was running more than 10% per year.
*** A friend, who is a contractor for the Pentagon, explained why there wasn’t more opposition to the expense of the war in Iraq: "Because they spend most of the money in the United States, not in Iraq." Still, $600 billion has been sucked out of the consumer economy for Iraq-related spending over the past five years…the final tally is expected to be in the trillions.
The Daily Reckoning