A Calm Hysteria

A Question of Confidence

Over the course of my investment career, there's never been a time when so many people have had so many emotional questions for me about the stock market and the economy. Every question is tinged with fear and concern and anger. At the same time, on the surface, life seems to be the same for most people.

Confidence is the essential ingredient in a modern economy and it has nearly vanished. People are creatures of habbit and they maintain their routines. But we are in danger that the panic will become so ingrained and do so much damage that it will take a long time and herculean efforts to regain that confidence.

Just in the last week I've had questions about what will happen if Citibank fails and if the auto companies fail. I talked to one person who has been to two funerals in the last month of friends or relatives who committed suicide because of financial stress. Another friend is abandoning his apartment because the property value has shrunk so much. Others are worried about their jobs and everything else.

At the same time, it can still be tough to get a parking place in a mall. And away from the TV news, the newspaper headlines and the computer screens, life seems shockingly normal.

It's always difficult to tell the difference during a recession and it affects everyone differently and most people haven't lost their job or their house. This recession is especially odd because the trouble was widely known for several years but it still burst into a full-blown crisis suddenly and with unexpected force. This panic has spread globally and taken us to places that most people thought we would never see.

While we know that the economy will be bad for months if not years, we still don't know how bad and that uncertainty makes things worse. Hearing people like Alan Greenspan say they don't know what's going on exacerbates the fear. We can only hope that the fear will abate, that the policy measures that have already been put in place will kick in over the next few months and that new solutions will be found.

Historic Times

For the Record

The S&P 500 Index fell Thursday to its lowest point since 1997, wiping out a decade of gains. In 2008 the S&P 500 is down 49 percent, which would be its worst annual drop ever. The S&P 500 fell 6.7 percent and the Dow fell 5.6 percent. Combined with the drop Wednesday, it was the biggest two day drop since 1933. Twelve stocks fell for each that rose on the New York Stock Exchange. That's a wipeout day. The S&P 500's drop from an October 2007 record is 52 percent: that is the worst bear market since the Great Depression.

Treasury yields declined to record lows, with two-year note rates dropping below 1 percent for the first time, in a rush to safety. Contracts to protect against corporate default rose to an all-time high. 

Life insurance stocks dropped for a fifth straight day on concerns that falling stock markets will lead to losses on retirement products. Lincoln National dropped 31 percent and MetLife, the largest life insurer, fell 13 percent. As a group, life insurers have lost two-thirds of their market value this year. The S&P 500 Financials Index, which includes insurers, banks and brokers, fell 11 percent to its lowest level since 1995.

The market briefly rose in the early afternoon after a report of a bipartisan plan to rescue the auto industry. Stocks started their steep late day drop after Congress told the auto industry to return in December with a detailed plan.

The  S&P 500 index rose or fell at least 1 percent in 86 percent of October's trading days, making it the second-most volatile month in its 80-year history. Only November 1929 produced bigger swings.

The Worst Year Ever

A Crisis of Confidence

The greatness of America lies not in being more enlightened than any other nation, but rather in her ability to repair her faults.
Alexis de Tocqueville

People can debate the long-term effects of the Financial Panic of 2008 but it certainly doesn't feel like the worst economy ever. It's bad but we've gone through worse before and not that long ago.

And yet, with barely six weeks to go in 2008, the stock market could be heading for its worst year ever. Worse than during the Crash of '87, worse than after 9/11, worse than during the Cuban Missile Crisis, the Tet Offensive, the oil embargo of the 1970s, Pearl Harbor. Worse even than the Great Depression.

The two worst years on record for the broad U.S. stock market were 1931 and 1937, in the middle of the Depression. In 1931, the stock market was down 43.3 percent and in 1937 it was down 35 percent. Those were huge declines and misery was everywhere.

As of Nov. 19, the S&P is down 45.07 -- the worst year ever. Last night a friend told me that the $32 trillion lost is just paper money. Well, all of our money now is paper money and our modern economy is highly abstract. But the losses are real and the effects are real and the economic collapse is real.

As FDR said when he took office, "There is nothing to fear but fear itself." There are real problems in 2008 but nowhere near enough to justify this level of panic. But the panic feeds on itself and sows real problems in its wake. Left unchecked, the problems will increase until they justify this decline in stock prices.

Why is the stock market such an important indicator? The stock market is like a very sophisticated series of medical tests and right now it is saying the patient -- the economy -- is very sickly. It's also saying that investors have lost all confidence. To invest in the financial markets and to invest in new plants and equipment and employees takes confidence that the economy will be strong in the future.

Does all of this mean the patient can't recover? Of course not. While the patient feels sick and he is miserable, a healthy future can seem a long way off and a return to health a chimera. But most patients recover in time and the right medicine helps.

What's needed urgently is the boost of confidence that can restore the essential optimism of Americans. I was talking to a European ex-pat last week and he said President-elect Obama's speech are nice, but what do they accomplish? In fact, soothing words may be just what we need. If in fact he can convey a sense that someone is in charge  and cares and knows what he is doing could be critical. The transition from a lame-duck administration has been a terrible time to have a financial crisis.

Right now our economy certainly needs more than speeches and the government has been doing quite a lot. These measure such as interest rate cuts, infusing money into the economy and propping up financial institutions will work over time. What's important is how much damage and suffering occurs in the meantime and how long the recession lasts. Anything that can restore confidence to businessmen and investors in America is urgently needed and will help us on the road to recovery.

The Mess in Numbers

Lots of Bad News

For banks, some borrowing is cheap and they still won't lend: The federal funds rate has averaged 0.29 percent since the Fed cut the rate to 1 percent on Oct. 29. The Fed is expected to cut the rate to a record low of 0.5 percent in December.

The losses in global stock markets is staggering: down $31 trillion while write-downs and credit losses have totaled $1 trillion in the worst financial crisis since the Great Depression.

Home prices dropped initially in only a few states but are now going down nearly everywhere: in 80 percent of U.S. cities. The median price declined 9 percent from a year earlier and one-third of sales involved a mortgage default. New home construction fell in October to an annual rate of 791,000 units, the slowest pace since records began in 1959.

The biggest declines were in California. San Bernardino median prices dropped 39 percent to $227,200, Sacramento down 37 percent to $212,000, and San Diego fell 36 percent to $377,300. Elmira, New York, had the biggest increase in the U.S., with a 13 percent rise to $105,000.

U.S. companies cut 1.4 million jobs in the last six months, the biggest reduction since 1975.

Retail sales have fallen every month since July, the longest series of declines in data going back to 1992. The Conference Board's index of consumer confidence that began in 1967 fell last month to the lowest ever recorded.

Oil prices have fallen 63 percent since reaching a record $147.27 a barrel in mid-July. Consumer prices last month fell by one percent, the largest amount since records began in 1947 as gasoline pump prices dropped by a record amount.

Besides energy, the big drop in inflation reflected widespread declines. Core consumer prices, excluding food and energy, fell by 0.1 percent last month, the first decline in core prices since December 1982 when the U.S. was emerging from two years of recession. The drop in consumer prices was a reversal from just a few months ago when rising energy prices raised concern that inflation was out of control.

An Exercise in Futility

The Perils of Prognostication

It sounds silly to say that we can predict the future. Yet that's what most investors are actually doing. If you are actively picking stocks or mutual funds (everything but index funds), you are an active investor. For most investors, that means you have a view about the future.

A few investors, deep value investors like Warren Buffet, look at the value of the assets of a company and see how the management has performed. If they can buy the assets cheaply enough, they believe they will do well. They claim to not need to make predictions. But even they must make some future judgments in valuing assets.

An alternative course is to say that we don't know what specific companies or industries will work well in the future but we have confidence in the overall economy and the stock market. These "passive investors" use index funds or other low cost vehicles to cover all or large sections of the market.

To illustrate the difficulty of predicting the future, let me give two examples.

Central bankers are paid to assess an economy's direction and figure out what to do to help it perform better. I'm not saying that it is an easy task, but that's their full time job. They have access to all the information in the world and talented staff.

And what have they done lately?

In mid-summer, the European Central Bank actually raised interest rates. They were worried about inflation. Could happen to anyone. Except that worldwide we'd already been in a financial panic for a year. The U.S., the world's largest economy and Europe's key trading partner, was slowing down rapidly. It was clear to anyone that inflation was not the problem with one caveat: oil prices had climbed to a record $147 a barrel and nominal inflation statistics looked bad. Peering behind the headlines, it was obvious that these prices were not sustainable in an economic downturn and that they would drop if demand dropped and demand was dropping rapidly.

A second instance of a central bank misfiring. In August, U.S. Federal Reserve Governor Richard W. Fisher voted to increase rates.

At the September 16 meeting, the entire U.S. Fed voted to keep rates unchanged. This was one day after Lehman Brothers failed and Merrill Lynch did a forced merger, the day that AIG needed an $85 billion bailout and one day before Treasury unveiled a $700 billion bailout plan. Markets around the world expected a Fed ease. The only reason that could be used in support of this decision is that the Fed thought rates were so low that no further cut would be helpful. That argument was demolished in October when the Fed did lower rates. The September statement also argued that both growth and inflation were significant concerns. They absolutely got that wrong.

If central bankers can't predict the economic future, how is it that you can?

The Vicious Cycle

What Could Stop the Downward Slide?

The economy has been in a strong downward slide since mid-summer. As people lose confidence, they stop spending, businesses cut back, people lose their jobs and so on. Each step builds on itself in a brutal downward slide. Financial companies have real problems and are cautious and won't lend. Businesses and consumers won't borrow.

John Maynard Keynes addressed this during the Depression. He called it a liquidity trap and said that in this instance monetary easing was like pushing on a string. An alternative, he felt, was government fiscal stimulus. What this means in plainer language was that if consumers and businesses wouldn't spend, the government would.

That's what we're doing now as the U.S. governments and other governments lay out trillions of dollars. Will this work? No one knows for sure but there's every reason to think that it will. Governments around the world have been throwing money at the problem. It takes time to achieve the desired effects. Given the widespread panic in evidence, it will take many months before we are sure that this is working.

A bad problem has been the timing of the U.S. election. With a lame duck president and so much uncertainty all fall, it has been  a difficult period. Businessmen and investors need as much certainty as they can get to make decisions. Moreover, different administrations have differing views of the causes and solutions.

Beyond the government fiscal stimulus, other things should eventually cushion the fall. Unlike in the Depression, there are many government transfer programs that support many millions of Americans. such as Social Security. In addition to which and private pensions and many other savings vehicles were virtually unknown in the 1930s.

Businesses have cut back so dramatically that inventories should be very low by mid-2009 and that could be a trigger for renewed economic activity. In addition, people should be adjusting to the realities of the recession by then and the fear should have passed. In that case, people revert to routine and that should benefit the economy as well.

While we can't know the dimensions of the recession and it could be long and drawn out, the financial markets should begin to recover before then. The stock market has already fallen this year more than in any year since 1931, so it's discounting a lot of bad news. It doesn't mean that the market has necessarily bottomed but it's not ignoring the recession either.

http://en.wikipedia.org/wiki/John_Maynard_Keynes

http://cepa.newschool.edu/het/profiles/keynes.htm

http://www.time.com/time/time100/scientist/profile/keynes.html

Global Downturn

Europe's Recession

Europe has entered its first recession in 15 years with sales, profits and hiring dropping rapidly. The European Central Bank responded belatedly with the fastest interest rate cuts in its history accompanied by fiscal stimulus in many countries. The ECB last week lowered its benchmark rate by a half point to 3.25 percent, the second cut in a month.

As recently as July the ECB raised rates to fight inflation. That move is now widely seen as a mistake. The downturn may last longer in Europe than in the U.S. and Asia because Europe was slower to respond.

Europe's economy is important to the U.S. because it is a major trading partner. As much as one-third of the profits of major U.S. companies comes from Europe and a decline in activity there leads directly to the loss of jobs in the U.S.

Europe's downturn surprised economists. In July they predicted a 35 percent chance of a recession in 2008. Policy makers expressed confidence that the economy would dodge a recession even as the U.S. faltered.

The major shocks hurting Europe's economy included the euro's rise to a record $1.60 in mid-summer (making exports too expensive), the strongest inflation in almost 16 years and oil's jump to $147 a barrel in July. The credit crunch then hit after the September collapse of Lehman Brothers.

(compiled from Bloomberg news and other sources)


Interesting Statistics

U.S. stocks yesterday rallied the most in two weeks, with the Standard & Poor's 500 Index jumping 6 percent in the final hour after being down significantly earlier in the day.

More than $30 trillion has been erased from the value of global equity markets this year as credit losses and writedowns totaled $959 billion in the worst financial crisis since the Great Depression.

Earnings for companies in the Stoxx 600 in Europe will fall 8.4 percent this year, according to data compiled by Bloomberg News as of Nov. 7. That compares with an estimate for 11 percent growth at the start of the year.

www.bloomberg.com

www.ft.com

Interesting Times

Extraordinary Numbers

There is an old Chinese curse: may you live in interesting times. This is certainly one of those times.

Everything about this financial crisis has been extraordinary. It didn't come out of the blue but it has been so much worse than even the most extreme pessimists predicted. It's too early to know how long this will last or how bad it will get. We know the effects will be pronounced for years even if the recession is short-lived.

Some of the most extraordinary numbers. Alan Greenspan said this is a once in a century financial crisis. Having been involved in economic affairs at the highest level for half a century, he should know.

Car sales for October were dreadful and the optimistic predictions for next year are for an annual rate of 12 million. The drop from last year is the worst in decades. Even when the economy went splat after 9/11, car sales hung in at a solid level.

Cars and housing normally lead the economy out of recession. Almost certainly, they won't this time. Housing is still declining rapidly, particularly in California, Florida and a handful of other states. Home values fell almost 10 percent in the third quarter, according to Zillow. Before the recent crisis, house values hadn't declined nationally since the Depression.

Peter Marcus, a steel analyst since 1961, said this week that the rate of decline in steel prices over the last four months was the biggest he's seen.Steel is a particularly economically sensitive product.

The decline in consumer spending for the Christmas season is projected to be the worst since 1942.

The stock market, as of today, is on pace for the worst annual decline since 1931.

Readings of investor fear and consumer confidence are close to record lows.

In short order one extraordinary event has followed another. In a single week, we had the complete reorganization of the investment banking firms, the failure of the largest insurer, the rescue of money market funds and the partial nationalization of a large part of our financial system. We also had the worst week in stock market history.

All of this is moving at such rapid speed and in such unusual direction that it would be folly to predict how this will unfold.

Buffet Interview on the Financial Crisis

"They Are Not Wrong to be Worried"

Last month Warren Buffet was interviewed by Charlie Rose on the current financial crisis. As usual Buffet offered the best analysis of the current situation and what to do about it. The complete transcript is well worth reading and the video of the show is also available. Below is an excerpt from the interview in which Buffet talked about how fearful people are now.

Charlie Rose:
There is a time to accumulate and a time to spend.

Warren Buffett:
Absolutely.  You want to be greedy when others are fearful.  You want to be fearful when others are greedy.  It's that simple.

Charlie Rose:
What are they now?

Warren Buffett:
They're pretty fearful.  In fact, in my adult lifetime, I don't think I've ever seen people as fearful economically as they are right now.

Charlie Rose:
Why is that, do you think?

Warren Buffett:
Well, it's because they -- they have seen the credit market seize up.  They're worried about money market funds, although the latest proposition from government should take care of that.  They've seen eight percent of the bank deposits in the United States get moved very skillfully, I might say, within the last couple of weeks from institutions that they thought were fine a few months ago to other institutions. They are not wrong to be worried.

Transcript
http://www.cnbc.com/id/26982338 

Video of Broadcast
http://www.charlierose.com/shows/2008/10/01/1/an-exclusive-conversation-with-warren-buffett

All Is Not Bleak

What Lies Ahead

Last night a friend called in a panic. After the worst two day fall of the stock market since the crash of 1987, he was highly agitated. He saw thousands of people losing their jobs and everything looked bleak to him. Normally people don't turn to me for a pollyannaish view of the world but this time I was optimistic and I tried to reassure him that things will get better.

First, the bad news. I don't have a crystal ball but after what's happened this fall, it's highly likely that the economy will be weak for months and unemployment will rise substantially. Some whole industries may disappear. The huge wealth destruction this year from falling house prices, the stock market collapse and lower interest rates will take a severe toll for a long time. All of this will have effects for  months and years. Housing and autos, which are big drivers of the economy, will have tough times for years.

But this too will pass and much of it will pass quicker than now seems possible. The headlines are all bleak but the positive things that are happening often don't make headlines. Recovery will take time and 2009 will be a bad year for the economy. But underneath the radar, new companies and industries will be forming and people will go about their routines. Quietly a new recovery will take shape. The good news is always less dramatic but not less important. It's not news when people go to the malls or hire one or two new employees. It's news when a major company lays off 10,000 people or closes a plant. But little by little, the economy will come back.

Among the most positive news is that governments around the world are now going all out to stem the crisis. I thought that they were behind the curve but the U.S., Europe, Japan and many others are now throwing their full weight against the downturn. The power of interest rates on government securities close to zero and powerful fiscal stimulus should not be underestimated. Much of the problem has been too much debt and lower rates over time will make it easier to service the debt.

From my perspective, the panic in financial markets and in the financial system has caught people's attention. It's not possible to know how deep the recession will be or how long it will last. But what we do know is that post-war recessions have lasted from six months to two years and unless this is something worse, we may already be half done and recovery can start as early as next year.

Yielding to Temptation

The Dangers of Being Trendy

It's natural since we don't know what the future holds to believe that current trends will persist. In investing, this can be a costly habit. Hot products tend to fade rapidly and cold products spring to life just when we've given up hope.

In the last few years it's easy to point to some areas where people were clamoring to participate right before the end. Early in the summer, everyone knew that they wanted to have commodities exposure in their portfolio. They knew that they wanted to own gold because it was going to keep going up. They had to own oil after it had gone from $20 a barrel to $150.

Then what happened? Oil had a record drop, declining 60 percent in a short time. Most commodities, including gold, cratered.The fever pitch was extinguished overnight and these commodities were left for dead. Does that mean they will never come back? Certainly not. Could they recover in the next few months? Possibly. Does anyone know for sure? Absolutely not.

Another good example is the dollar. For five years, the dollar declined compared to most major currencies. Against the Euro, the dollar lost nearly half its value. Everyone knew that the dollar would continue to decline for years. Then what happened? In a few months the dollar rallied more than 20 percent versus the Euro and everyone stopped talking about it.

More impressive still was the private equity bubble. In private equity, investors have formed giant funds to acquire public companies or pieces of companies that they think are undervalued. The private equity investors generally attempt to refinance and improve the business and then resell it in a few years at a significantly higher price.

As with other trends, this started with some good ideas. Under-performing businesses or parts of businesses often gained a new focus and performed better under new management. Sometimes hidden assets were highlighted.

However, as with other trends, this simply went too far. Too much money poured into the area and the pressure to make gigantic multi-billion dollar deals overcame the ability to find good ones. Competitive pressure drove up the prices and introduced too much risk and debt into the transactions.

Private equity deals became so pervasive that they propped up the entire stock market until debt financing started to become scarce in June 2007.

Nothing better highlights the quick spike and demise of the private equity bubble than the case of General Electric. The trend had gotten so absurd that in June 2007 the Wall Street Journal ran an article talking about how much more General Electric would be worth in a transaction than it was currently selling for in the stock market. At the time, G.E. was the most highly valued company in the world.Fortunes fell so fast than in September 2008 in the midst of the financial crisis, G.E. raised $12 billion in a stock sale to bolster its financial businesses.

All this came to our attention again today when Blackstone, the world's largest private equity firm, posted a loss of $500 million, only 18 months after it became a public company.

On Wall Street, all trends hold peril and its wise to keep to sound investment principles and not get carried away the latest great fad.

Slow and Steady Wins the Race

The Road to Recovery

After the big stock market decline this fall, there's a temption to try to make up lost ground quickly. That's likely to be a mistake. Instead, it makes sense to put a plan together and stick to it.

By trying to recover quickly, one is apt to take too much risk. While we can win those bets sometimes, the global meltdown this fall has been an instructive lesson in the dangers of inappropriate risk.

There's also the temptation to take no financial risk and that's just an illusion. Every course of action involves risk. Keeping savings in cash (besides the unusual risk we had this fall) involves the "opportunity cost" of losing out on potential investment gains as well as the loss of purchasing power from inflation. A dollar simply won't buy as much in a year as it does now.

Taking too much risk brings the possibility of loss of principal.That has been readily apparent this year. What has not been apparent has been the virtue of long-term investing in the stock market.

With the wild gyrations the market has been taking, it's too easy to look on it as a risky "casino." While that may be true in the short run, it's not the case for the long run. Money that is needed within five years shouldn't be in the stock market. For longer term money, the odds are that it will produce satisfactory returns if it is properly diversified.

Over the last 90 years -- which is as long as we have good data -- the stock market has returned 10 percent per year as measured by large cap U.S. socks. Properly diversified into other categories, particularly small cap value and international stocks, returns have averaged two to four percent higher. At 10 percent per year (and for the moment ignoring fees and taxes), money doubles every seven years. At 12 percent, investments double in six years. If an investor has an IRA, which builds up funds without taxes till withdrawal and minimizes fees, he can get close to these returns.

With these kind of returns, financial accumulation is powerful  -- tripling in twenty years without undue risk. The key to getting these powerful returns is broad-based diversified in low fee funds with a tilt toward small cap value.