Thursday, October 23, 2008

Closer to the bottom

The most expensive investment that most people will make in their lifetime is comfort. When the herd is confirming that stocks are the way to certain wealth and security we naturally conform to that view. After the bear market of 2002 the explosion in fixed annuity sales is legendary as those burned proceeded to self immolate again with low return "safe" investments.

We are at the inflection point of change. The news media doesn't let us forget for a moment. Stunned investors don't open their statements for fear of what is within.
Even those who can say, "I told you so" are being trotted out ad nauseum into the now believing public eye.

Turn off the television, put down Time magazine and think. What did we do wrong? Why? Were they errors of analysis or errors of trust? We live in a world of never ending information flow and very little wisdom flow. It is simply the nature of our time. One does not think clearly when still gathering information no matter how useless it may be.

I too was caught in the minutae because the minutae moves markets; for a day or a week, perhaps a quarter. It is not how I see the world, but the current is strong when swimming against it and sometimes it wins.

Now to continue the metaphor a bit longer, we've dragged ourselves onto the shore breathless and a bit battered. Now the journey continues.

For all the chaos and panic in both economy and financial markets, this it the time patient investors have been waiting for. But it should be done right and coherently.

I have a friend who through the grace of dumb luck and a job change left her 401-k 100% in the Stable Value Fund offering. While others were losing ten's of thousands, she made $25. Recently she has put 10% into an S&P Index Fund. Even if the market becomes even more apocalyptic I estimate her downside risk is 3% of her portfolio if the market drops another 30%.

Create a structure and then stick to it. Get help if you need it.

John Barnyak

Friday, October 17, 2008


Among the last people listened to in the midst of investment happy talk are the academics and economists who look at economies and markets with dispassionate and skeptical eyes. It is not until their always early analysis bears fruit do they become the darlings of the media.

Noriel Roubini, Nassma Taleb, Gary Shilling are all academic economists and financial analysts. The dry arcane analysis got it right long ago. The popular gadabouts trotted out with their selective proof of events will slip beneath the waves as they always do. Jerry Bowyer who appears in the last youtube video with Mr. Shilling is a hack, but its amusing to look back on the certainty that the hack had.

Past these links in your browser to listen to some intriguing takes on the market today. The third, Gary Shilling, from early in the year is particularly prescient.

John Barnyak

Wednesday, October 15, 2008

Round 3 of a Heavyweight Fight

Every so often, when the market hits an air pocket, analysts trot out the Nikkei Index of japanese stocks and overlay it on the S&P 500. The point being that the japanese succeeded in turning a market bubble into a two decade zombie market. The reluctance of Japanese banks to write down inflated real estate assets after the 1990 collapse resulted in both a market and an economy that has alternatively sputtered and failed to regain its footing for the better part of two decades. The failure of Japanese policymakers to deal with the banking problems quickly and effectively created a dead man walking market.

Whether we have avoided the same fate is unclear, but thus far the signs are not good. I am in fact confident we will not have the "L" recession of Japan, but rather a protracted "U". Innovative, aggressive and politically unpopular solutions will be needed. Hopefully in times of extrordinary need, extrordinary people will raise to the occasion.

Several items give me serious pause. The entanglement of the economy and the credit crisis is masking the issues. It is great that the federal government gathered the banking powers that be into a room and acted like it was making fois gras by stuffing money down the throats of the John Mack and others. But stuffing a goose with grain doesn't make instant pate'.

We are clearly entering a significant recession. Today's release of the Empire State Manufacturing Survey shows clearly that more difficult times are ahead. All indicators were negative and the general business condition index dropped to a record low. The allure of thinking that unfreezing credit will avert a recession has been too strong perhaps. Phrases like, "America is on sale," and "buying opportunity of a generation," have been ringing across the airwaves. I doubt it.

The current earnings estimates for companies are already beginning to be lowered. From the current S&P 500 earnings estimate for 2008 is $77.81. As the most recent quarterly earnings come in we are seeing a significant number of companies surpassing expectations, but the same companies voiceing concern that they will be able to meet year end consensus. In other words, the fourth quarter looks like a serious drop.

The current estimate of analysts puts the S&P earnings at $104.16. On the cusp of a recession and estimates of earnings growth in 2009 of 34.2%? I take that with a grain of salt.

Clearly the financial sector will do better next year. The comparisons with bankruptcy should be pretty easy to surpass. But every other sector shows substantial growth as well. My estimate, which I believe to be hopefully conservative is $68. The historic mean P/E for the broad group is 11. In severe recessions it has troughed as low as 7.

At 11 times $68 the S&P would reach 748. At 7x, 476 we would return to the level of the mid 1990's. It sounds preposterous, but the Maestro Greenspan oversaw three successive bubbles as a result of easy monetary policy. It is not impossible the we could see the unwinding of all three. We already reached 844 for the index which is within 12% of a very reasonable long term investment level. Emotionally, the exhaustion of the past 2 weeks has created a pause. Much of the panic is out of the market but there is still plenty of opportunity for "disappointment", when expected bounces fizzle out.

The first round was the subprime mortgage crisis which emerged in all its glory a year ago. It would appear we have an understanding of the issue now, although no adequate solution has yet been provided.

The second round was the resulting credit crisis as the banking system froze and institutions stopped lending to each other. The lubricant of the capitalist system stopped flowing. The injection of capital into the banks and government guarantees of debts on new transactions should allay these fears substantially. I am not confident the capital is sufficient, but the decision was the first right one I believe.

Round three is the recession which was going to arrive in any case, but has been given a massive dose of testosterone by the credit smack down. The prospect of an average recession has receded and one of greater depth and duration looms. Unfortunately the usual remedies for an economic slowdown, i.e. interest rate policy is already exhausted. There are no bullets in that gun.

The next president will have to take a deep breath, show leadership the likes we have not seen in a generation and call upon us to decide who exactly we are as a nation.

John Barnyak

Tuesday, October 14, 2008

Portfolio Strategy

I believe the worst of the credit crisis is past. The trillions of dollars of liquidity, equity and loan guarantees past two days from governments around the world should stablize the financial markets.

Yesterdays nearly 1000 point advance was a welcome relief after the relentless recent negative days. Now we have to get back to reality after the very surreal events of the past month. That does NOT mean investors should begin a feeding frenzy based on the media's comments that "America is on sale." It's not.

With the melting of frozen credit facilities we can once more look at the basic issues of valuation, earnings, and longer term market action. The truth is, we were going to get to this level anyway. The credit debacle has brought the market down faster than any previous bear market including the Great Depression. This has truly been a collapse of historic proportions.

There are a number of opportunities within this crisis. Things investors should be doing in a very difficult time. It is not time to abandon long term strategies, but it may be time to clear the decks and mind.

Review portfolios for holdings that no longer make strategic sense. Individual stocks that have lost their purpose and competitive advantages in particular. Indexes and diversified funds will return to positive ground in time. Specific companies many never.

Tax strategies need to be reviewed now for yearend, but this subject is better handled in a single posting because of the many aspects it entails.

After a serious market correction, very often the new leaders in the market are not the same as the past leaders. Remember the Sun Microsystems or Corning, then we had the housing stocks like Toll Brothers, then materials stocks like US Steel, Consol Coal or Alcoa. Don't be afraid to take a very critical eye to holdings because the next winners are very likely not yet in your portfolio.

John Barnyak

Monday, October 13, 2008

Karl and Groucho Do Wall Street

It seems ironic that the failure of Marxism has turned in recent days to resemble the, hopefully, temporary failure of free market capitalism. For all the wailing about the impending socialism of effectively nationalizing banks and investment firm with public money if we scratch a bit deeper we find the profession of the free market to be less pure than we ever imagined.

The failure of Marxism was a failure of human character. The mortgage debacle which is at the foundation of the current financial crisis is an agent/principal conflict, a model made for character failure. The risk has been divorced from the risk creator. Even within the investment banks themselves, the complexity of the financial engineering masked risk.

In business transactions there are principals and there are agents. Principals are those who ultimately bear the responsibility as owners for either the loss or the profit. Agents, are like a real estate or stockbroker. Incentivized by the transaction, not the result. Much like the chicken and the pig at breakfast. The chicken is involved, the pig is committed. The current financial collapse was to a large result the result of too many chickens, not enough pigs.

The financial allure of transaction based compensation for so many participants in the real estate bubble created the moral hazard that one's behaviour had no consequence. The mortgage broker needed merely to sign another borrower up and send the mortgage to Countrywide for his commission. The property appraiser needed only to bump up the valuation a little to help grease the skids to move the process along. The easier the valuation, the more business would come from the happy mortgage broker. All along the line, quality was replaced by quantity. Who knew such a simple matter was the seed of such chaos?

An irresponsible freemarket sowed the seed of it's own demise. No is the time for responsible intent to right it again.

John Barnyak

We're Going to Need a Bigger Boat

I admit, I've been a little busy the past two weeks or maybe like the entire investment industry stunned by the speed and violence of the market collapse. Last week as each day brought another stunning loss in the market it reminded me of a shark attack. Shark victims often report feeling nothing but the hit, no pain. The shear historical magnitude of the past month takes on on almost academic amazement to the point you hardly notice you are being devoured.

It became increasingly clear that no one with policy power had any control or any idea of what to do. We watched as credit markets froze. Traders used to making hundreds of billion dollar trades a day reported they had made none in three weeks. Companies limped along with diminished funding options and anecdotal stories of canceled investments and diminishing economic activity spread.

Everyone searched for data that went back one hundred years rather then just twenty. Depression? Japanlike twenty year zombielike economy? I doubt either to be the case, but it takes some nerve to watch markets take entire bear market hits in a week.

Have we seen the bottom? Possibly, but there is a lot of work to do even in a well diversified portfolio. The carefully constructed non-correlated portfolio discovered in a deleveraging world, everything is correlated. Corporate Bonds, Stocks, foreign and domestic, commodities, real estate.

Open the belly of this beast and you'll find it ate just about anything.

John Barnyak

Wednesday, October 1, 2008

Skin in the Game

The current crisis is revealing much about the state of our nation and its polarized views of the world. All week we have heard talk of Main Street and Wall Street as if they do not coexist. Until we can address problems such as this from a more unified approach I fear it will not just be credit which is frozen, but much of the hard work of running a nation of the people.

Main Steet and Wall Street are inextricably bound in a gordian knot of shared interests. It is the benefits which have been asymetrical not the interests themselves. The increasing disparity in the benefit of economic growth does not encourage a perception of shared pain nor of shared solution. The public view that the bailout is a socialization of losses by those who would seek to keep capitalism alive only when profitable is arguable, but perception is truth.

Unless our leaders and politicians can craft a financial rescue bill that makes Joe Six Pack feel like he has skin in the game the voters will react with ugliness come November. That we are at the beginning of a lengthy period of pain is not in doubt. But let taxpayers feel like there may be shared gain and I have faith the country can come together. On the otherhand, we have hidden a war from Main Street, why not a financial crisis too?

John Barnyak