More Bad Numbers

It's Bleak but not Hopeless

Boeing announced that in February they only received four orders for freight and passenger jets. The previous year they got 125 orders. That's a year over year decline of 97 percent. In good years, Boeing is the single largest U.S. exporter. So this is bad news for manufacturing jobs and our trade deficit. Orders are a forward looking indicator with new orders delivered years in the future, so this doesn't mean a collapse of current production. Anyway you look at it, it's not good. The only plus is that across the board, inventories are getting leaner and eventually people will want stuff again.

Planning for Sunnier Days Ahead

Comeback Insurance for the Stock Market

Some day the sun will shine and the flowers will bloom and the economy will recover. Companies will still be in business and begin to grow profits and the stock market will rise again. It's hard to look past the current carnage but how do you prepare for a brighter future? Do you abandon the stock market permanently as two generations of Americans did after the Great Crash and the Depression? Or do you participate as did the people who reentered the market and enjoyed a two decade bull market after World War II.

One way to participate is to put together an ultra-diversified portfolio. Think of an ultra-diversified portfolio as comeback insurance for the stock market. In normal times, diversification is seen as a luxury or something that prevents you from racking up big gains. In tough times, it may be the difference between riding out the storm and getting permanently sunk.

What is ultra-diversification? In simple terms it means buying lots and lots of different things. So far in this super bear market, everything has been falling and falling a lot. It hasn't mattered what stocks you owned anywhere in the world; they've all gone down. Usually that's not the case and this is unlikely to last forever.

Even now financial stocks -- primarily banks -- have been hammered mercilessly. While the broad averages are down roughly in half since the bear market began, Citicorp is down more than 95 percent from its peak of the last year and many formerly blue chip stocks are down nearly as much. While they may regain prior values, it will be a long tough slog and many may never regain their formerly lofty heights.

Trying to foresee the future is always difficult. Now it's impossible. The carnage of a bear market and steep recession obscure the good things that are happening in the economy. By the time they become apparent, the next bull market leaders will have already made big gains. The best way to capture those gains is by holding broad batches of stocks.

While some fallen angels will recover, it's much more likely that the broad market averages will benefit fully from the eventual economic recovery. Oftentimes, only a handful of stocks, industries or geographies benefit from a market move. In 1998, the S&P 500 rose more than 20 percent. That increase was accounted for entirely by fewer than ten stocks, mostly big technology companies. Without those, the index actually would have been down slightly for the year. Picking them out ahead of time was nearly impossible. Two years later to do well one needed to hold small cap value stocks and no technology. A few years later, the ticket was energy stocks.

Who is that nimble? Who is that adroit?

By the sheer law of large numbers -- if enough monkeys press on the keyboard, they'll eventually produce Shakespeare -- someone will appear to be doing well. Is it luck or skill? It may be skill in some small number of cases but even if it is, it's nearly impossible to identify that skill ahead of time. Those who persist in trying to find that rare skill more likely hold themselves open to scams or legitimate but equally devastating disappointment.

The solution is easy. Hold everything. Hold a little bit of as many securities as you can all over the world. You'll capture the best and the worst but over time these returns have been robust. Including the Great Depression of the 1930s and the current unpleasantness, stocks over the years have returned more than 10 percent a year on average. That means that a portfolio doubles every seven year on average merely by matching the market returns. While no year is average, over the long term -- 10, 15, 20 years -- returns begin to converge on those averages. That may seem like a long time but investing, as opposed to speculating, is a long-term proposition. For those who truly want to invest, the wait is worth it and the returns that accrue are spectacular. It just takes patience and heeding the fundamentals of investing.

Ultra-diversification means holding thousands of securities around the world. The most widely held index funds, those based on the S&P 500, naturally enough hold 500 of the biggest U.S. stocks. That's good most of the time but what about when small stocks do well or Asian stocks? In the early 1970s you needed to own big fast growing stocks. In the late 70s it was commodities and small stocks -- how to know that ahead of time? How to know to jump off commodity stocks in 1980 after a great five year ride and not get back on for more than twenty years. How to know to get off small stocks in June 1983 after a great eight year ride and not get back on for almost a decade. Who knew that tech would be a disaster for most of the 80s and the ticket in the 90s before being a disaster again?

A guest on television got it right last summer. He said that if you think you know what's going on, you're just not paying attention. He was being honest and right.

No one knows where the winners will come from and the best chance to hold them is to buy as many different securities as you can all over the world. A few mutual funds hold thousands and thousands and they are well worth searching out. Look at the actual holdings, not the names. Just because something says "world" or "total" doesn't mean it has as many names as possible. No one knows the optimal number to be properly diversified, but if the cost is reasonable, more is better. And remember, a few holdings, those needles in the haystack that can rise 10 - 50 - 100 times, can make all the difference and just make sure you have them.

The Silver Lining

The Yin and Yang of Economics

Everything is bleak. It seems that forever the business news has been a sea of gloom.  Companies announce layoffs by the tens of thousands. The stock market had its worst start to a year ever. People criticize the proposed stimulus plan as something that will take too long to work. Concerns rise that with interest rates already close to zero, monetary policy can't help. It's easy to see what industries --- autos, housing -- are struggling. It's much less clear what will lead us out of the mess.

But big problems lead to big solutions. It's the yin and yang of economics. In good times, problems accumulate and they are dealt with in bad times. The seeds of prosperity are planted in the bad times. In recent decades, the U.S. has been fortunate. The down parts of the business cycle, recesssions, have been short and mild compared to earlier periods. In the 1980s and 1990s we had record post-war expansions. In the 1990s growth and productivity accelerated to levels that many thought were no longer possible given the size and maturity of the U.S. economy.

The bad news will continue for a long time, likely several more years. Already, though, there are many encouraging signs. We won't know for some years when the economy hits its trough and the shape of a recovery are still a matter of conjecture. But many important things are clear.

The best news is that it's likely that the greatest systemic risk is well behind us. In mid-September, panic raged globally. In one week in mid-September at least one huge event happened every single day that I never thought I'd see in my lifetime. That week Lehman Brothers failed, AIG and money funds needed to be bailed out, Merrill Lynch, Goldman Sachs and Morgan Stanley needed to be rescued and put under the cover of commercial banks and the TARP program initiated and the stock market had its worst week every. That week was perilous to the system. Each misstep carried the risk that panic would so dominate the system that confidence would be crushed and recovery would be measured not in months or years but decades.

Subsequent weeks were not as bad but the cumulative effects of the financial crisis kept building. Matters hit a head over Columbus Day Weekend. By then various rescue plans had come and gone and global markets kept shrugging them off. Risk aversion and fear reached record levels. The danger was that these bad impacts become self-reinforcing and would not burn out of their own accord until they laid waist to large swaths of the world economy.

Over that weekend, Britain took the lead by directly injecting capital into its banks and the U.S. and others followed. That Monday, Columbus Day, the global markets responded favorably and the cycle of fear and panic was temporarily broken. The peak period of fear, while diminished, lasted another month but the greatest danger of widespread failure was past.

People are creatures of habit and fear can remain at extreme levels for only a short period (it's unusual for peak fear in the markets to last two months). Then they revert to their normal routines. People adjust and behaviors change but the strongest habits persist as long as the environment permits.

Outwardly, daily life for most people has changed little but in some ways economic life has had drastic changes. A generation will retire later. Many people will lose their homes, move, switch industries, require further education and have much diminished lifestyles.

But out of this widespread pain, many opportunities will arise. Just as a forest fire enriches the soil and opens sunlight for new plants, an economic downturn creates new opportunities. It forces people and businesses and the government to rethink old and outmoded ways of doing things and be open to new opportunities. In good times,it's hard to shed old habits. In bad times, people have to change. The U.S. had grown fat and happy, now it's time to switch to lean and mean.

It's easy to see where the difficulties lie. The financial system, judging by past bubbles, will not fully regain its vibrancy for many years if not a decade or more. But new industries will take its place. It's less obvious where the new leadership will be. Starting off the 1990s, no one predicted that high technology will play the leadership role that it did and the Internet did not begin to shine until midway through the decade. The New York Times had a cover story this week exploring where the new opportunities lie, http://www.nytimes.com/2009/02/01/magazine/01Economy-t.html?_r=1&ref=magazine.

A possible encouraging sign is that this downturn has been so fast and so sharp that the economy may have overshot to the downside. Car production is down by nearly half and home building has plummeted. The same happened in many industries but to a lesser extent. As a consequence, inventories may become too lean sometime in the first half of 2009. With hundreds of billions of dollars parked at near zero interest rates and the stimulus package underway, a reversal of the extreme risk aversion could get economic activity flowing rapidly again.

The rebounds from the past few recessions have been sluggish but this is the sharpest and longest decline in a long-time. The rebound, whether it begins this year or next year, could be equally abrupt. Even if its not, the financial markets have been beaten down so much that their response could be surprisingly swift.

Saving the TARP Bad Asset Buyout

Turning Bad Assets Good

The heart of the response to the U.S. financial crisis last fall was the $700 billion TARP program. The on again, off again program was to buy bad assets from banks and free them up to lend again and reinvigorate the economy.

A few weeks after arguing that this program was essential to saving the world economy, the Treasury and Federal Reserve backpedaled and decided to use the money to inject equity directly into the banks.

While that was a worthy objective and essential to enabling the banks to resume lending, it left the financial markets puzzled. What was the Treasury really thinking and did they know what they were doing? If the bill was named the Troubled Assets Relief Program, why wasn't it dealing with troubled assets?

Dealing with an unprecedented crisis strains, the financial markets were panicking and the critical thing in shortest supply was confidence. Treasury's flip flopping and floundering squandered whatever confidence was left.

In reversing its decision to purchase bad assets, the Treasury cited as their biggest obstacle figuring out how to price assets. That's a question that Treasury and the Fed had danced around during Congressional testimony in September and later.

The problem in a nutshell is this. Because no one wants to hold illiquid assets now, prices have plunged. In a few years, when institutions are more willing to assume normal risks, these assets may rebound significantly if their intrinsic value remains the same. The Federal government can add these assets to its balance sheet now and wait a few years for the increase in price and an expanded number of buyers.

But which price should the Government pay? The current low market price, the expected higher future price or something in between?

The answer is critical because the idea is to help these financial companies recover so they can provide the wherewithal to get the economy moving again. If the Government pays too little, it won't help the banks. If it pays too much, it will feel like a chump and taxpayers will be taken for a ride.

The real answer may be that the Government should inject money now and worry about the price later.

Here's how that would work. Think options. The Government would pick an arbitrary middle price and pay the banks that money now. That would help the banks get back to work, lending money to sound borrowers. The Government would sell the assets it is acquiring over a period of years. If the Government got good prices, it would split the upside with the banks. If it realized lower prices, it would collect some of the difference from the banks.

This would accomplish three major things. It would help repair the balance sheets of the banks now and restore confidence. We would avoid the thorny problem of pricing for now but a market-based mechanism would be used in the future. This would avoid the problems and possible corruption of arbitrarily setting prices. Finally, this would bring transparency to the process and boost investor confidence which is a critical step toward recovery.

Stock Market Suffering a "Lost Decade"

Once in a Lifetime Financial Crisis

Most people now agree that the current financial crisis is a once in a lifetime collapse of the world economy. While we don't yet having any way of knowing the ultimate depth of the contraction, the threat to the world economic system has been the greatest since the Great Depression of the 1930s.

In a single week in mid-September, the last of the major Wall Street investment banks failed or became commercial banks, the largest U.S. commercial insurance company had to be bailed out with more than $125 billion, money market funds began to fail and needed to be guaranteed to prevent a run and Congress debated a bailout of the commercial banking system. In short, in one week, under a conservative Republican laissez faire administration, the U.S. went from a regulated but free market financial system to a heavily government run network of financial intermediaries. And everyone could only hope for the best.

That week turned out to be the worst in stock market history with a decline of about 18 percent in the broad averages. As one commentator put it a few months earlier, "If you think you understand what's happening, you aren't paying attention."

To put stock market performance in perspective, the stock market is flirting with declines that challenge the worst performance since we began keeping good records in 1926. That includes the current record-holding period of the 1930s, when the brunt of the Great Depression hit. Depending on which of the broad averages one uses, last year's decline was about one-third, which was the worst calendar year performance since 1931 or 1937 (the S&P 500 and Dow Jones Industrial Average respectively). All told, about $7 trillion of stockholders' wealth vanished in the U.S. (wiping out the gains of the last 6 years) and approximately $26 trillion disappeared worldwide.

By some measures the market could still decline further based on estimates of market declines during past financial crises. A study by economists Carmen Reinhart and  Kenneth Rogoff of past financial crises, http://www.economics.harvard.edu/faculty/rogoff/files/Aftermath.pdf, would indicate a further ten percent decline is possible.

Using another measure, however, this is already one for the record books. Over time the stock market has trended upward at a pace of about 10 to 11 percent per year. That trendline is consistent over long periods. Individual years differ widely with gains as high as 54 percent (S&P 500 in 1933) to a decline of 43 percent (S&P 500 in 1931).  Over longer periods, the market, which reflects economic activity, is much more consistent. Good decades make up for bad decades and the returns catch up with the long-term trends.

Prior to the current decade, the worst decade, not surprisingly was the 1930s, with an annualized return of -0.1 percent per year, or nearly flat. In the 1940s, spurred by a post-war boom, the annualized return was +9.2 percent, followed by an ebullient market in the 1950s, returning +19.4 percent per year. The first half of the 1960s was relatively strong followed by weakness later in the decade as inflation hurt the economy. For the decade, the annualized return was +7.8 percent. In the 1970s, which had two big recessions and rampant inflation and a big bear market mid-decade, the return for the whole decade was still a positive +4.6 percent. In the 1980s, a two-year recession gave way to a long-term recovery and bull market and a +16.1 percent annualized return. The 1990s followed a similar pattern with an early recession giving way to a record peace-time expansion and an annualized return of +17.9 percent.

Now we are nearing the end of what may turn out to be the "lost decade." The Dow, the most popular market barometer, breached 10,000 in 1998. It now hovers around 8,000 or a decline of 20 percent. For the decade of the 2000's, the annualized return to date of the S&P 500 is -6.8 percent. Using the S&P 500, the broadest major indicator, and calculating by decade, this will be the worst decade in the 80 years of modern record keeping unless the market returns to near record levels and rallies by close to 75 percent this year. While possible, it certainly doesn't seem likely and this period is likely to go into the record books as the worst decade for the market in the modern era.

The silver lining in this debacle is that the market tends to revert to the trendline over time. That means good periods eventually follow bad ones. Great bull markets are borne in the ashes of terrible bear markets. While the sunshine won't necessarily break through soon, eventually the storm will depart.

Super Bowl Indicator Bodes Well for Stock Market

Steelers, Cardinals Provide Grounds for Optimism

The Pittsburgh Steelers should bring back cheer to Wall Street. For many years investors have tracked the outcome of the Super Bowl as a strong indication of whether the market would go up or down for the year. Despite the silliness of the linkage, it has proven a more reliable indicator than most expert predictors. Over the years, the indicator works about 80 percent of the time. Chance alone would mean it should work only half of the time.

The indicator holds that when a team from the National Conference or an original NFL team is the winner, the market will go up. If an old AFL team wins, the market will go down. Views differ on how to treat expansion teams that have joined the league since the AFL and NFL merged in 1970.

Both the Arizona Cardinals and the Pittsburgh Steelers should lead the market up this year and we certainly could use that after the worst calendar decline in more than 70 years. The Steelers seventh appearance in the big game augurs even better. After their six previous appearances, the Dow has always risen.

This is the first appearance in the Super Bowl for the Cardinals so they are an unknown for the stock market. However, their status as the NFC representative is a good omen.

The Steelers have won five previous Super Bowls tying them with the San Francisco 49ers and the Dallas Cowboys for the most championships in modern football history. If the Steelers win this Super Bowl -- and they are favored -- they would stand alone as the most successful NFL franchise.

Along with that record of on field performance, they have a chance to be the best talisman for the stock market. In five appearances in the Super Bowl, the 49ers were victors each time and the Dow rose an average of 20.7 percent but there was one losing year for the market, 1990. The Cowboys have made a record eight appearances in the game and the Dow has risen 10.2 percent per year, slightly below the long-term average, and there was also a losing market year in 1978.

The Steelers alone have never ushered in a losing year in the Dow and their long-term average return is 19.6 percent. If the market rises 27 percent this year they will eclipse the 49ers in every market related way. While that would require a big rally, last year's 34 percent drop was one of the biggest in market history. A 27 percent rally would only bring the Dow to 11,146, the closing level in mid-September 2008.

New York Giant fans may be disappointed that they did not repeat their trip to the Super Bowl but market participants should be relieved. Their victory last year should have led to an up year and instead the big drop was one of the biggest dents so far in the indicator. In four trips to the Super Bowl, the Giants have left behind disappoint markets, averaging a drop of nearly five percent.

While all of this may seem overly whimsical in the midst of a serious financial crisis, most American market participants do take their pro football seriously. And while there is no reason to assign any cause and effect to the Super Bowl Indicator, people move billions of dollars every day on flimsier evidence than this. In any case, all investors would be well served by joining the legions of Steeler fans around the country in a hearty chorus of Go Steelers.

Overcoming Fear

Learning the Wrong Lessons from the Stock Market Crash

Investors always gravitate between fear and greed. The pendulum had swung too far toward greed in recent times. Now investors have been traumatized and the danger is that they will stay fearful and lose opportunities.

Both extremes are bad. Being too fearful is less destructive than taking too much risk but it is still a huge problem. Whether someone is saving for their first house, to send children to college or to have a secure retirement they must invest prudently. But to do that, they must accept prudent risk. Every investment carries some risk whether an investor identifies that risk or not.

A measure of the level of panic is the investment posture of major institutions. Short-term treasury bills are being issued at close to zero percent interest. What that means is that major market players are willing to hand over their money to the biggest borrower in the world in return for -- nothing. There are trillions of dollars under the government's mattress and major institutions are asking for nothing in return except for a piece of paper that says the U.S. government will give the money back, with no interest, at a specific time.

So if the big institutions panic, should individuals panic too? While panic was certainly justified for several months in the fall -- just because I'm paranoid doesn't mean someone isn't out to get me -- one should examine the current environment in weighing investment decisions.

It's highly likely that the world economy will go through a brutal slump for most of 2009 and recovery for late 2009 or even 2010 is problematic. While there are some grounds for being more optimistic, it's not necessary to rely on that to chart an investment course.

Going back as far as we have good records, to 1926, the broad stock market has increased on average by more than 10 percent per year. That takes into account the 85 percent drop during the Great Depression, the dark days early in World War II when the Germans and Japanese raced toward victory, the brink of nuclear war in the Cuban missile crisis, the ravages of inflation and the prolonged economic slump of the U.S. in the 70s and early 80s and the tech stock collapse at the dawn of the millenium. Through all that, the stock market has recovered and grown in line with the economy.

On average through all those bleak periods and boom periods, the stock market has doubled every 7 years and quadrupled every 14 years. It's never smooth and never guaranteed but it has worked for a long time. While there were periods this fall when it looked like the world economy could completely derail, the greatest danger seems past. Now it is a matter of being patient and enduring pain but the outcome should be similiar to that of all the many times over the last century.

Most investors do not have access to anything that can equal the returns of stocks over the long term. Investing in a broadly diversified representation of the stock market makes it possible to realize those returns with the least risk. Investors should not abandon that avenue as part of their investment arsenal just because of some recent trauma -- the second worst year of the last century. This too shall pass. From past experience we also know that whenever the market does recover, it is likely to be suddenly and with big moves. A big part of the gains will be concentrated in a short period and few people will realize what has happened until after it is over.