“Our plan would keep many more Americans in their homes, and put government money into local communities where it would make a difference. By clarifying the true value of each loan, it would also help clarify the value of securities associated with those mortgages, enabling investors to trade them again. Most important, our plan would help stabilize housing prices.” – John D. Geanakoplos and Susan P. Koniak.
I have written in previous posts about various proposals to stem the tide of mortgage foreclosures. Today’s New York Times Op-Ed piece Mortgage Justice Is Blind by John D. Geanakoplos and Susan P. Koniak is the latest entry.
They cover familiar territory, blaming subprime loans and securitization and quickly summarize the problem.
The current American economic crisis, which began with a housing collapse that had devastating consequences for our financial system, now threatens the global economy. But while we are rushing around trying to pick up all the other falling dominos, the housing crisis continues, and must be addressed.
We start with this simple fact: Too many families are being thrown out of their homes when it makes more sense to let them stay by “reworking” their mortgages — adjusting terms to make it possible for the homeowners to meet their responsibilities. In many cases, adjusting loans would help the homeowners and the lenders: the new mortgages would have lower monthly payments that homeowners could afford to pay, and would end up giving the lenders more money than the 50 cents on the dollar that many foreclosure sales are bringing these days.
To arrive at their solution, the authors first focus on the incentives of the “master servicer” which manages the pool of loans that are bundled together. In the old days when one banker lent money to one consumer each knew the other. If the borrower experienced financial difficulty, the lender had the ability and the incentive to renegotiate the mortgage.
With the advent of securitization, it is the “master servicer” who manages hundreds if not thousands of mortgages. They have very little incentive to rework the loans, fearing legal liability from investors. In addition, Geanakoplos and Koniak point out that the servicers will not be adequately compensated for the extra work.
As a result, “the master servicer now holds the power to rework the loans. And, as we have seen in the current crisis, these servicers aren’t doing that, as house after house goes into foreclosure.”
To solve this problem, we propose legislation that moves the reworking function from the paralyzed master servicers and transfers it to community-based, government-appointed trustees. These trustees would be given no information about which securities are derived from which mortgages, or how those securities would be affected by the reworking and foreclosure decisions they make.
Instead of worrying about which securities might be harmed, the blind trustees would consider, loan by loan, whether a reworking would bring in more money than a foreclosure. The government expense would be limited to paying for the trustees — no small amount of money, but much cheaper than first paying off the security holders by buying out the loans, which would then have to be reworked anyway. Our plan would also be far more efficient than having judges attempt this role. The trustees would be hired from the ranks of community bankers, and thus have the expertise the judiciary lacks.
Americans have repeatedly been told that the distressed loans cannot be reworked because these mortgages can no longer be “put back together.” But that is not true. Our plan does not require that the loans be reassembled from the securities in which they are now divided, nor does it require the buying up of any loans or securities. It does require the transfer of the servicers’ duty to rework loans to government trustees. It requires that restrictions in some servicing contracts, like those on how many loans can be reworked in each pool, be eliminated when the duty to rework is transferred to the trustees.
Under our plan, servicers would provide the homeowner’s name and other relevant information on each loan to a central government clearing house, which would in turn give trustees the data on homes in their local area. Once the trustees have examined the loans — leaving some unchanged, reworking others and recommending foreclosure on the rest — they would pass those decisions to the government clearing house for transmittal back to the appropriate servicers.
The servicers would then do exactly the same work they do now, passing on the payments they collect from the reworked mortgages to the securities’ owners in each pool. The servicers would also foreclose on those properties the trustees had decided did not qualify for reworking. For performing those tasks, the servicers would continue to receive the fees due under their existing contracts.
We need an innovative approach to overcome the gridlock that plagues our housing markets. Otherwise, we imperil millions of homeowners and — through the alchemy of derivatives — the American and global economy.
I think their solution to the problems of falling home prices, abandonment and foreclosure is very interesting. It adds to previous suggestions.
News reports have indicated that the Bush Administration will unveil their plan shortly. We’ll see what aspects of the various proposals they will recommend.
“Bear markets sometimes end with a bang, sometimes with a whimper. You’re more likely to see a unicorn in your backyard or a chimera in your kitchen than you are to spot an indisputable sign of market capitulation.” – Jason Zweig.
Of late, I have been writing about the possibility that the current stock market decline could end with a great big bang, followed shortly thereafter by investor disgust and despondency. It’s more of an intellectual exercise, because I am basically an agnostic on the subject. Frankly, no one really knows whether or not we will have such a “selling climax.”
Jason Zweig’s Intelligent Investor post on October 25 is called Capitulation: When the Market Throws in the Towel. Surprisingly, Bear Markets Don’t Always End With a Bang — Sometimes It’s Just a Whimper. His point of view is worth reading and emphasizes that we just never know what will happen.
There’s a belief that the market can hit bottom only when vast numbers of investors finally capitulate, throwing in the towel and selling off the last of their stock portfolios. In theory, if you could spot this moment, you could make a killing buying at the bottom.
There are two problems here. First, capitulation is almost impossible to define. Second, even if you could get a positive ID on capitulation, that might not do you any good. Market lows aren’t necessarily marked by tidal waves of frantic selling; just as frequently, stocks bottom out in a dull and lonely atmosphere as trading dries up and most investors no longer even care. Bear markets often end not in capitulation but stupefaction.
Oddly, even market pundits who believe in capitulation admit they can’t define it. “Capitulation is a state of mind, without any specific definition,” says Al Goldman, chief market strategist for Wachovia Securities. “You can’t measure it; it’s best identified in hindsight.” Hugh A. Johnson, chief investment officer at Johnson Illington Advisors, says almost wistfully: “I wish I could quantify it for you so I could say, ‘Here, this is capitulation.’ But a lot of this is anecdotal. Talk to enough investors and you get an idea of whether we have capitulation.”
“The most interesting thing about [the 1974 market bottom] was its dullness,” veteran fund manager Ralph Wanger recalled to me. “It wasn’t a crash, it was a mudslide. You came in, watched the market go down a few points and went home. The next day you went through the same thing all over again.” And then, without a moment’s warning, the bull woke up and took off. By Jan. 6, 1975, the market had shot up 10%, and a year after that the Dow had risen 54% from its 1974 low.
In short, bear markets sometimes end with a bang, sometimes with a whimper. You’re more likely to see a unicorn in your backyard or a chimera in your kitchen than you are to spot an indisputable sign of market capitulation.
The obsessive attention so many investors are paying to the huge swings in the Dow suggests that we may not have hit bottom yet; stupefaction seems not to have set in yet. What we can be quite certain of, however, is that stock markets around the world are already on sale. If you have cash to spare, put some to work. If you don’t, save up until you do. But don’t kid yourself into thinking that you will ever get a clear signal out of such an unclear indicator.
I sincerely hope that my posts have not added to the “obsessive attention” to the stock market swings. I believe that when an investor owns, even a single share of stock, he actually owns a share in a business. A share of stock is not like a lottery ticket, and it’s more than just a piece of paper based on numbers that crawl across the bottom of a TV screen.
As providers of capital, investors are entitled to a return. In the short term, returns can vary tremendously. Historically, over the long term, stocks have returned more than safer investments.
As for the short term, i.e. what we are living through now, there are dramatic factors that have been causing stock prices to decline – specifically, margin calls and hedge fund redemptions.
An example of a margin call is a company’s CEO who had earlier borrowed money to exercise company stock options. Because the company’s stock price has since declined in value, the CEO must either put up more capital or sell the stock in the account to meet the broker’s margin requirement.
Hedge funds have been selling stocks, currencies, commodities – basically whatever they could sell – to prepare for imminent redemptions. This is, in effect, “forced selling,” similar to margin calls. And there is just no way to know when this will all end.
Since everyone knows this, it is possible that stock prices already reflect the negative situation. If that’s the case, this could be a great “buying opportunity” for stocks. Unfortunately, we will only know if we were right in retrospect.
“These types of forecasts are wildly off-base. What they’re always about is extrapolation. People are always extrapolating recent trends. And you don’t know how far the trend is going to really run.” – William A. Fleckenstein.
This post is a continuation of articles on how no one can predict the stock market or any other market, for that matter.
Going for the Gold in Gloom and Doom by Michael M. Grynbaum has an analysis of the phenomenon of people who make predcitions that are extreme. They not only confidently assert their forecasts, but they are frequently wrong. And they are not held accountable for their mistakes.
“Financial forecasters are in a race to call the bottom to the bear market. And just as on the way up, when analysts competed for attention with their forecasts of bigger and bigger gains, the financial pundit class now seems compelled to out-gloom the next guy.
“To make a crazy forecast today is not crazy,” said Owen Lamont, a former professor at Yale who has studied economic forecasting. “It’s not crazy to predict the Dow is going to 2,000. That’s in the realm of possibility.”
“Even in normal times, forecasters have a strong incentive to make extreme predictions, which is why those “Dow 1,000!” reports persist. “It’s eye-popping. It’s relevant. It seems exciting,” Mr. Lamont said. Such predictions attract publicity, name recognition and a bigger client base in a business where investors pay thousands, if not millions, for stock advice and investment guidance.
And even if a forecast is off-base, there are few repercussions because they are almost always quickly forgotten. “The reason that people do these games is because no one’s really tracking accuracy,” said Mr. Lamont, who now works at DKR Capital, a hedge fund in Greenwich, Conn. “No one is carefully, prudently giving more business to the guy who is 2 percent more accurate than the next guy.”
Some say this is a system that propagates ignorance and poor advice.
“Anyone that invests 10 cents on the basis of someone’s forecast of the Dow is desirous of losing a good portion of their 10 cents,” said William A. Fleckenstein, president of Fleckenstein Capital, a money management firm in Issaquah, Wash. “It is almost the height of arrogance to say this is where the Dow is going to trade.”
“These types of forecasts are wildly off-base,” Mr. Fleckenstein said. “What they’re always about is extrapolation. People are always extrapolating recent trends. And you don’t know how far the trend is going to really run.”
Some financial pundits, however, are all too happy to broadcast their predictions to the public, no matter how apocalyptic.
Peter Schiff, the president of Euro Pacific Capital in Darien, Conn., and a prominent financial Cassandra, has seen some of his most dire forecasts confirmed amid this year’s turmoil. On Friday, he predicted plenty more pain to come.
Forecasters who get too far ahead of themselves would do well to remember an instance of notoriously poor prognostication. One of the few times that a financial strategist has been widely taken to task came in 1999, when Kevin A. Hassett and James K. Glassman published “Dow 36,000: The New Strategy for Profiting From the Coming Rise in the Stock Market.”
The book, which arrived just months before the technology bubble burst and stocks plummeted to earth, was actually an argument that bonds and stocks should be considered as equally risky investments. But the title — cartoonish in hindsight and, in its authors’ defense, proposed by the publisher — has since become a popular punch line for jokes about irrational exuberance in turn-of-the-century Wall Street. (The Dow closed on Friday at 8,378.95).
Still, while the reputation of its authors may have taken a hit, “Dow 36,000” has not seemed to hurt their careers.
If you had taken their book seriously, you would be much poorer. But while their predictions were way off the mark, both authors have done just fine. One has a prestigious position with the American Enterprise Institute and one with the Bush Administration.
Wildly optimistic forecasts and wildly pessimistic predictions are often wrong. Frequently the prognosticators are merely extrapolating the recent past. The main thing they accomplish is to gain attention for themselves. If you listen to such predictions and act on them, you do so at your own risk.
Barry Ritholtz, who writes a very popular blog, The Big Picture, often discusses the causes of the financial crisis. How Lending Standard Changes Led to the Housing Boom/Bust, posted on October 21st, blames the problem squarely on the lax standards of lenders. I agree with his main point, which he makes persuasively. Maybe it is a question of emphasis, but I believe that there is enough blame to go around.
Many of us acted as if housing prices could only go in one direction – up. Individuals bought as much house as they could get approved for. Some investors/speculators bought several condos when they were under construction. They hoped to “flip” the apartments as they were completed, thereby making exceptional profits.
With the very low interest rates promoted by the Federal Reserve, there was a big demand for any investment that promised higher returns. Investment banks packaged questionable mortgages, and investors bought the complicated financial instruments without asking enough questions. Rating agencies blessed the securities with triple A ratings, never imagining that home prices could actually fall substantially. Regulation did not keep up with the changing markets for securitized debt instruments.
This housing bubble or mania could not go on forever, and it did not.
Here is Ritholtz’s article.
There is a general lack of understanding as to how the Housing boom and bust occurred, and why it led to the subsequent credit freeze. The situation is complex, and that is why we are still explaining this 3 years into the housing bust.
Let me take another shot at clarifying this:
Underlying EVERYTHING — housing boom and bust, derivative explosion, credit crisis — is the enormous change in lending standards. I am not sure many people understand the massive change that took place during the 2002-07 period. It was more than a subtle shift — it was an abdication of the traditional lending standards that had existed for decades, if not centuries.
After the Greenspan Fed took rates down to ultra-low levels, home prices began to levitate. More and more mortgages were being securitized — purchased by Wall Street, and repackaged into other forms of bond-like paper. The low rates spurred demand for this higher yielding, triple AAA rated, asset-backed paper.
In this ultra-low rate environment, where prices were appreciating, and most mortgages were being securitized, all that mattered to the mortgage originator was that a BORROWER NOT DEFAULT FOR 90 DAYS (some contracts were 6 Months). The contracts between the firms that originated mortgages and the Wall Street firms that securitized them had explicit warranties. The mortgage seller guaranteed to the mortgage bundle buyer (underwriter) that payments were current, the mortgage holders were valid, and that the loan would not default for 90 or 180 days.
So long as the mortgage did not default in that period of time, it could not be “put back” to the originator. A salesman or mortgage business would only lose their fee if the borrower defaulted within that 3 or 6 month contractually specified period. Indeed, a default gave the buyer the right to return the mortgage and charge back the lender the full purchase price.
What do rational, profit-maximizers do? They put people in houses that would not default in 90 days — and the easiest way to do that were the 2/28 ARM mortgages. Cheap teaser rates for 24 months, then the big reset. Once the reset occurred 24 months later, it was long off the books of the mortgage originators — by then, it was Wall Street’s problem.
This was a monumental change in lending standards. It created millions of new potential home buyers. Why? Instead of making sure that borrowers could pay back a loan, and not default over the course of a 30 YEAR FIXED MORTGAGE, originators only had to find people who could afford the teaser rate for a few months.
This was a simply unprecedented shift in lending standards.
And, it is why 293 mortgage lenders have imploded — all of these bad loans were put back to them. Note that the fear of this occurring is what was supposed to keep the lenders in line. The repercussions of this is why Greenspan believed the free market could self-regulate. (After all, people are rational, right?) One of the many odd lessons of this era is that, under certain circumstances, companies and salespeople will pursue short term profits to the point where it literally destroys the firm.
If you want to point to the single most important element of the Housing boom and bust, this is it. Ultimately, these defaulting mortgages underlie the entire credit freeze. And, it would not have been possible without the Greenspan ultra-low rates, which made the teaser portion (the “2″ of the 2/28) of these mortgages so attractive.
Contrary to the cliche, failure is not an orphan in the current crisis — it has 100s of fathers. But these four are the primary movers, the key to everything else. The perfect storm of ultra-low rates, securitization, lax lending standards and triple AAA ratings — these are the key to how we ended up with the previous boom, followed by a bust, and ultimately, the credit freeze.
“The most common cause of low prices is pessimism – some times pervasive, some times specific to a company or industry. We want to do business in such an environment, not because we like pessimism but because we like the prices it produces. It’s optimism that is the enemy of the rational buyer.” – Warren Buffet.
In a previous post, I raised the possibility that we might witness a kind of panic selling called capitulation. This was not meant to be a prediction. It was an observation that sometimes a bear market ends in a very sharp decline, and it is generally associated with investors’ extreme discouragement and/or disgust. This is not an exact science, but more like Justice Potter Stewart’s comment on pornography – you’ll know it when you see it.
Well at 7:30 this morning, the futures markets indicate a very weak opening for U.S. stocks. This is happening after markets had steep declines in Asia, with the Japanese stock market falling almost 10%. European stocks have also declined by 7-10%. Right now it looks like we are going to have a “Terrible, Horrible, No Good, Very Bad Day.” (Judith Viorst) Of course, no one knows where the market will close today or what will happen next week.
For more context, Mark Hulbert’s column Anatomy of a Bottom, written for MarketWatch on October 21st, describes the difference between a “Panic” and “Capitulation.”
Capitulation has a number of distinguishing psychological characteristics, such as investor disgust and exhaustion. Having been burned by the market for so long, investors capitulate by resolving never, ever, to trust the market again.
In the wake of capitulation, therefore, interest in the market declines. Apathy rules.
To be sure, this definition cannot be mechanically measured. It is hard to pinpoint when investors become maximally dejected and apathetic. But my hunch is that we have yet to experience capitulation.
One illustration of capitulation that I find particularly instructive, even though it is from a pre-Internet era: During bull markets, as well as during bear markets up until capitulation finally occurs, investors turn to the business sections of their morning newspapers to see how much they made or lost the previous day. At times of capitulation, in contrast, investors don’t even bother to open the business section at all.
From the perspective of this illustration as well, capitulation is yet to occur: Far from being ignored, business news is now splashed all over the front pages of newspapers’ lead sections.
My guess is that, when that low does finally occur, we’ll be witnessing, and experiencing ourselves, a lot more of the psychological traits associated with capitulation: Exhaustion, disgust, lack of interest, even apathy.
Interpretation and Advice
Investors, by definition, are “in it for the long run.” If the recent events on Wall Street, and indeed, across the globe, have you so discouraged that you question whether stocks really do provide higher returns than bank CDs, then you are in the grips of capitulation. How you behave or how you react, at this moment, will be what determines your rate of return for a long time to come.
If you sell when everyone else is selling, you may get some immediate psychological comfort that you have come in out of the storm. My belief, which is based on extensive experience, is that you will do yourself harm in the long run.
What happens to stock prices in the short term is anyone’s guess, but if investors are not rewarded for taking risk by investing in stocks, capitalism cannot function.
“There are plenty of legitimate reasons to be concerned about our economy and the markets right now. But worrying that your retirement security might be jeopardized should your fund company fail isn’t one of them.” – Walter Updegrave.
Imagine the worst (which is currently not that difficult) and your mutual fund firm declares bankruptcy. Walter Updegrave, Money Magazine senior editor, discusses this scenario in an article published October 15th online: When investment Firms Go Bust. If you are feeling nervous about your mutual fund firm, this article will give you comfort.
Question: If an investment firm like Fidelity or T. Rowe Price goes bust would I lose the money I have in mutual funds in IRAs and other accounts? —Gerry Cheok, Gaithersburg, Maryland.
Answer: Already in this financial crisis, we’ve seen investment banks, commercial banks and mortgage firms fail or require some sort of government bailout to keep them afloat.
To date, however, no mutual fund companies have bitten the dust or required a government loan or investment to prevent them from going under. I hope that will continue to be the case, although in this wild and wooly market, I suppose anything is possible.
But the good news is that even if a fund family were to get in trouble or go belly up, the money you have invested in mutual funds – whether in an IRA, 401(k) or any other type of account for that matter – would still be safe.
Indeed, the value of your mutual fund accounts is pretty much unrelated to the health of the fund company itself.
Why? Several reasons.
Separation of assets
First, the money you invest in a mutual fund doesn’t actually become part of the assets of the mutual fund firm, as is the case when you buy a CD at a bank. Instead, your money goes to whichever mutual fund you’re buying. You receive shares in the fund for your investment, and the fund manager then invests your money in securities that become part of that fund’s portfolio of assets.
And although most people think that the mutual fund firm – be it Fidelity, T. Rowe Price or any other fund sponsor – owns the mutual funds with the firm’s name on them, that’s not the case.
The fund firm – or sponsor as it’s known in fund industry lingo – merely has an agreement with the fund to manage its assets and sell the fund’s shares. The fund itself is a separate entity from the sponsor and has its own board of directors. And the owners of the fund are the fund’s shareholders, the people like you who have invested money in the fund own its shares.
That goes for all the securities in the fund as well – stocks, bonds, Treasury bills, whatever. The mutual fund firm doesn’t own them either. The fund’s shareholders own them. So if a mutual fund company were to get into financial trouble or go into bankruptcy, the assets of the individual funds would not be available to the mutual fund company or its creditors to meet the firm’s obligations.
No funny stuff
But, ah, you may ask, in dire circumstances wouldn’t the mutual fund company somehow manage to dip into the till even if only temporarily to get them out of a financial bind? Couldn’t fund shareholders’ money be at risk that way?
Actually, the odds of a struggling fund company getting its hands on fund assets are remote at best. To avoid such malfeasance, federal law requires that the securities owned by a mutual fund be held separate from the fund’s sponsor in a custodial account, usually at a bank or trust company. The fund’s assets are also segregated from the custodian bank’s or trust company’s assets as well.
Finally, to protect shareholders from the possibility that a dishonest employee of the mutual fund company, custodian bank or some other person could get at a fund’s assets, federal law requires funds have fidelity bond insurance which covers instances of fraud, embezzlement and the like.
I’ve sketched the main outlines of how mutual funds operate. But if it would make you feel better, you can get more detail by checking out this investment company fact book.
Should you be worried?
If your mutual fund company were to fail, the assets of your fund would be secure, totally insulated from the fund sponsor’s financial problems. The failing mutual fund company would arrange for another mutual fund company to assume management of your fund, or your fund’s board of directors would do so. Either way, you and other fund shareholders – who are still the fund’s owners – would have to approve the new arrangement.
Of course, these protections have nothing to do with the market value of the funds you own in IRAs or other accounts. That will be determined by the market price of the securities owned by your fund. If your IRA is invested in shares of a mutual fund that tracks the overall stock market and the stock market drops, so will the value of your IRA. But that has nothing to do with the financial health of your fund company.
To sum up, there are plenty of legitimate reasons to be concerned about our economy and the markets right now. But worrying that your retirement security might be jeopardized should your fund company fail isn’t one of them.
“Look at market fluctuations as your friend rather than your enemy; profit from folly rather than participate in it.” – Warren Buffett.
I do not believe in the concept of market timing, because no one knows what the short term direction of the stock market will be. An educated guess is about the best anyone can make. That is why a buy and hold strategy, using a well diversified portfolio, works best for most investors.
Given their own, sometimes naïve, perceptions, investors can become either too optimistic or too pessimistic. Unfortunately, it is typically easier to identify these times after the fact.
It is very easy to make predictions that turn out wrong, even if you are very knowledgeable.
For example, former Federal Reserve Chairman Alan Greenspan warned about “irrational exuberance” in 1996. He clearly thought that the high stock prices of 1996 could not be justified. Nevertheless, the stock market went up in 1996, 1997, 1998 and 1999. Eventually, in March of 2000, stock prices began their steep decline. Needless to say, if you had heeded “Financial Guru” Greenspan’s warning in 1996, you would have lost out on 3 – 4 years of profitable gains.
In October 2002, after stock prices had fallen almost 50% from their previous highs, a lot of investors “threw in the towel” and basically gave up on stocks. They sold their holdings and stayed out of the stock market for several years. Many of those investors compounded their mistake by switching from equity mutual funds to variable annuities. (That is a topic for another post.)
Let’s assume that, right now, given the current economic climate, the majority of investors are pretty pessimistic about the future. How can we tell? There have been plenty of indicators. Stock prices have already declined more than 35% from their year-ago highs. Banks have been afraid to lend to each other. Institutional investors (pensions, university endowments) have been pulling massive amounts of money out of hedge funds. Many individual investors have been heavily selling mutual funds. And many people, and institutions, have flocked to short-term Treasury securities, because they are known to be extremely safe investments, albeit very low yielding ones.
Now, suppose stock prices continue to fall, resulting in investors becoming even more pessimistic than they already are. How could this happen? Well, what if so many investors decided to redeem their accounts that hedge funds needed to sell off even larger amounts of stocks, bonds, and commodities just to fulfill the investors’ demands. What if individual investors continued to sell their stocks and mutual funds, only doing it in greater amounts and with far more urgency?
Panic Versus Capitulation
What is this called? Well, panic is one term. Capitulation would be another. You may be hearing this particular term more often now. What would capitulation look like? Probably like the end of the world. The Dow Jones Industrial Average would fall by 800 – 1,000 points or more in a single day. And just suppose that that the selloff continued for a second day. Imagine the ominous discussion on TV. Investors would feel discouraged, disgusted and positively sick. One reaction might be, “Get me out now, at any price!”
If that happens, and there are certainly no assurances that it won’t, then this may in fact be the best possible time to buy more stock. Of course, it is very difficult to even consider buying when prices are actually plummeting and everyone is afraid. (You should note that it is incorrect to say that there are “more sellers than buyers.” In point of fact, there is a buyer for every seller, or more aptly put, each share to be sold will be bought. It is just that the sellers are willing to accept lower stock prices than previously was the case.)
I do not know if the capitulation phase of the bear market will occur. In Prepare for the Revulsion Stage Janice Dorn, Chief Global Risk Strategist, Ingenieux Wealth Management, Sydney, Australia predicts that capitulation of investors will probably happen. Here’s how she envisions it.
Now, we are likely to see a washout where just about everyone who has not sold will give up and sell. They will walk away from the markets and vow never to return again. This will be the complete revulsion stage. Only when this happens will the markets be in a position to begin to rebuild the technical damage. This will take time, and it now appears that the highs in the broad indices have been seen for many years to come.
People will have nightmares about the Great Crash of 2008 for years to come. They will lose trust in the entire financial system and in many of their advisors who allowed their accounts to lose somewhere between 25% and 50%. The small retail trader will leave the markets in disgust and distrust.
Dorn’s description is quite graphic. And she is saying that it is likely to happen. Make no mistake, she is predicting a once-in-a-generation change in investor perception. We’ll see if this extreme reaction comes to pass.
But please remember that stock market lows can only be identified in retrospect. Moreover, for people who follow a buy and hold approach, all of this may be of only intellectual interest. On the other hand, knowing that this kind of panic behavior can happen may steel you not to join the herd in selling at what may just be the wrong time.
“The key to successful investing is to get the plan right and stick to it. That means acting like the lowly postage stamp that does one thing, but does it well: It sticks to its letter until it reaches its destination. The investors’ job is to stick to their well-developed plan (if they have one) until they reach their destination. And if they don’t have a plan, write one immediately.” – Larry Swedroe
What can investors learn from the mistakes of investment banks, such as Lehman Brothers and Bear Stearns? That question is what Larry Swedroe addresses in his article: Anatomy of a Crisis: Lessons Learned From the Credit Crunch. Swedroe believes that one should not judge a strategy “solely on the outcome.” Nevertheless he identifies the “major strategic errors” investment banks made.
First, they “bet the house” by using too much leverage, meaning the company would go bust if these bets lost. Highly leveraged institutions must be right all the time because even if they are correct in the long term, they may not weather a short-term storm. This is a lesson these institutions should have learned from the 1998 experience of hedge fund Long-Term Capital Management (LTCM).
Second, they failed to effectively diversify risks, placing too many eggs in just a few highly correlated baskets (such as residential and commercial real estate).
Third, they forgot that even if assets have low correlation, risky assets have a nasty tendency to have their correlations turn high at the wrong time.
Fourth, they treated the unlikely (housing prices falling sharply) as impossible. They also forgot that just because something had not happened does not mean it cannot.
Fifth, they failed to understand that liquidity can be illusory: there when you don’t need it, but “gone with the wind” when you do.
Lessons Investors Should Learn
- Investment banks and active managers (including hedge funds) cannot protect investors from bear markets. All crystal balls are cloudy … If their money managers could protect you, why did Lehman Brothers and Bear Stearns go belly up and Merrill Lynch have to run into the arms of Bank of America to prevent the same fate? …
- Never take more risk than you have the ability, willingness or need to take.
- Diversify broadly, and don’t concentrate labor capital and financial assets in one basket. Many employees of once-great companies lost not only their jobs but also much of their financial assets because they made this mistake.
- For fixed-income assets, stick only with government bonds and the highest investment-grade bonds. Anything else (such as junk bonds and preferred stocks) can have the risks show up at the wrong time.
- We live in a world of uncertainty (the odds of events occurring cannot be measured), not a world of risk (the odds can be measured). Thus, stocks are high-risk investments, no matter how long the investment horizon. That is one reason for the large equity risk premium.
- Treat neither the unlikely as impossible, nor the likely as certain. And, if something has not yet happened doesn’t mean it cannot or will not.
- Make sure your investment plan incorporates the high likelihood of crises. The only way to avoid them is to not take risk, and thus accept Treasury bill returns. While bear markets are painful, there is no good alternative to buy and hold except to avoid risk. Timing the market is a mug’s game.
As further evidence against the folly of market-timing efforts, a study on 100 pension plans that hired the “best managers” around to engage in tactical asset allocation (a fancy term for market timing) found that not one had benefited from the efforts.
“Housing prices are continuing to decline. Until that decline is halted, bad things are going to continue to dominate this country’s — indeed, the world’s — economic life.” – Joe Nocera.
Shouldn’t We Rescue Housing?, Joe Nocera’s column in Saturday’s New York Times, focuses on the problem of house foreclosures and what must be done to stop a downward spiral.
So far, under the Rescue Plan, the Federal Reserve has added a tremendous amount of liquidity to the banking system. In addition, “the Treasury Department just pumped $125 billion into the country’s largest financial institutions, and it promises to use another $125 billion — more, if necessary — to recapitalize regional and community banks.”
They are vital steps. This week, at long last, the credit markets thawed, at least a little, and the global recapitalization of the banking system is the reason.
But the job isn’t done yet. The government now needs to tackle what R. Glenn Hubbard, the former chairman of the Council of Economic Advisers under President Bush, calls “the elephant in the room”: the continuing decline of housing prices.
I’ve seen estimates suggesting as many as one out of every six homeowners has a troubled mortgage. This is an enormous social problem. It is also a continuing economic problem. In the year since the crisis began, the world’s financial institutions have written down around $500 billion worth of mortgage-backed securities. Unless something is done to stem the rapid decline of housing values, these institutions are likely to write down an additional $1 trillion to $1.5 trillion. In other words, we ain’t seen nothin’ yet.
If housing prices keep falling, many millions of additional homeowners will find themselves, through no fault of their own, with underwater mortgages. Besides, foreclosures damage property values for everyone, not just those losing their homes.
Nocera mentions Sheila Bair, chair of the Federal Deposit Insurance Commission, and her efforts to do more for homeowners; the Hubbard and Mayer plan to allow all residential mortgages on primary residences to be refinanced into 30-year fixed-rate mortgages at 5.25 percent; and Yale economist John D. Geanakoplos’ recommendations to “modify mortgage loans to keep homeowners in their homes.” Nocera is sent many plans to solve the foreclosure problem. Here is one he really likes.
But recently a proposal came across my desk that I believe is so smart, and so sensible, that I hope our nation’s policy makers will give it a serious look. It comes from Daniel Alpert, a founding partner of Westwood Capital, a small investment bank. I have quoted Mr. Alpert frequently in recent columns, because he has been both thoughtful and prescient on the subject of the financial crisis.
Here’s his idea: Pass a law that encourages homeowners with impaired mortgages to forfeit the deed to their lenders but allows them to stay in the homes for five years, paying prevailing market rent. Under the law Mr. Alpert envisions, the lender would be forced to accept the deed, and the rent. After five years, the homeowner-turned-renter would have the right to buy the home back, at fair market value, from the lender.
There are so many things I like about this idea that I hardly know where to begin. Let’s start with the fact that it doesn’t require a large infusion of taxpayers’ money. Indeed, it doesn’t require any government money at all. It also doesn’t let either homeowners or lenders off the hook, as many other plans would. The homeowner loses the deed to his home, which will be painful. The lending institution, in accepting prevailing market rent, will get maybe 60 or 70 percent of what it would have gotten from a healthy mortgage-payer. (Rents are considerably lower than mortgage payments right now.) That will be painful too. Moral hazard will not be an issue.
“We cannot assume that even if the economic news gets worse that prices will decline further. It’s quite possible that prices are already reflecting investor concerns of more trouble ahead and may rise despite more gloomy business reports in days and months to come.” – Weston J. Wellington.
Today’s New York Times has two editorials, both of them well worth reading; one was written by Nobel prize-winning economist Paul Krugman and the other by Warren Buffett, the chairman and chief executive officer of Berkshire Hathaway, who is touted as one of history’s most successful investors. At first glance, their respective opinions seem to be diametrically opposed, but that is only true if you don’t understand how the stock market works.
In Let’s Get Fiscal, Krugman assesses the outlook for the economy saying that there is “grim news coming in about the real economy.” Summing up the economic situation, he states,
Just this week, we learned that retail sales have fallen off a cliff, and so has industrial production. Unemployment claims are at steep-recession levels, and the Philadelphia Fed’s manufacturing index is falling at the fastest pace in almost 20 years. All signs point to an economic slump that will be nasty, brutish — and long.
Krugman predicts that the unemployment rate, which is already above 6 percent, “will go above 7 percent, and quite possibly above 8 percent, making this the worst recession in a quarter-century.”
“And how long will it last? It could be very long indeed.”
Upon reading that, it would be understandable if you decide to sell all of your stocks and put the money from the proceeds “under the mattress,” so to speak. If you’re at all in agreement with Krugman’s analysis, you might want to buy “safe” CDs or, if you are totally freaked out, short-term U.S. Treasury securities, that are paying very close to zero interest.
That understandable inclination of reacting to bad current news, and worse predictions of the future, though perfectly natural, would likely also be entirely wrong. The reason is that the stock market looks forward. What is already known is “priced in the market.” Stock prices have already fallen in anticipation of a worsening economy. If and when the economy declines further, that will only confirm what we think we know now, so stock prices may not decline any more from where they currently stand.
In other words, as an investor, you cannot read the news or even someone’s prediction on where the economy is going and “profitably” act on it. In the stock market, “what everyone knows is not worth knowing.”
Please note, that nowhere does Krugman give any advice on what to do as an investor. That’s not his area of expertise. I am only projecting what a knowledgeable layman might conclude from reading Krugman’s observations.
That brings me to Warren Buffett’s opinion piece. It is an understatement to say that Buffett is a very, very, successful long-term investor. He’s been called, among other things, the Oracle of Omaha and the world’s greatest stock market investor, and an empire builder. His favorite holding period is “forever.” He certainly does not try to time the market, as he believes no one can do that successfully. (There is a lot of academic evidence that people who do try to time the market end up with terrible results.)
In Buffett’s Buy American. I Am, he agrees with Krugman’s basic thesis on the economy.
The financial world is a mess, both in the United States and abroad. Its problems, moreover, have been leaking into the general economy, and the leaks are now turning into a gusher. In the near term, unemployment will rise, business activity will falter and headlines will continue to be scary.
But here is the seeming paradox. What is Buffett doing?
I’ve been buying American stocks. This is my personal account I’m talking about, in which I previously owned nothing but United States government bonds. (This description leaves aside my Berkshire Hathaway holdings, which are all committed to philanthropy.) If prices keep looking attractive, my non-Berkshire net worth will soon be 100 percent in United States equities.
A simple rule dictates my buying: Be fearful when others are greedy, and be greedy when others are fearful. And most certainly, fear is now widespread, gripping even seasoned investors.
Since no one can forecast the short term direction of the stock market, Buffet continues:
Let me be clear on one point: I can’t predict the short-term movements of the stock market. I haven’t the faintest idea as to whether stocks will be higher or lower a month — or a year — from now. What is likely, however, is that the market will move higher, perhaps substantially so, well before either sentiment or the economy turns up. So if you wait for the robins, spring will be over.
This is typical Buffett — folksy, but right on. He then writes about the Great Depression and World War II, and notes that buying when things look bleakest was the right strategy. He concludes that “bad news is an investor’s best friend. It lets you buy a slice of America’s future at a marked-down price.”
Over the long term, the stock market news will be good. In the 20th century, the United States endured two world wars and other traumatic and expensive military conflicts; the Depression; a dozen or so recessions and financial panics; oil shocks; a flu epidemic; and the resignation of a disgraced president. Yet the Dow rose from 66 to 11,497.
You might think it would have been impossible for an investor to lose money during a century marked by such an extraordinary gain. But some investors did. The hapless ones bought stocks only when they felt comfort in doing so and then proceeded to sell when the headlines made them queasy.
Today people who hold cash equivalents feel comfortable. They shouldn’t. They have opted for a terrible long-term asset, one that pays virtually nothing and is certain to depreciate in value. Indeed, the policies that government will follow in its efforts to alleviate the current crisis will probably prove inflationary and therefore accelerate declines in the real value of cash accounts.
Equities will almost certainly outperform cash over the next decade, probably by a substantial degree. Those investors who cling now to cash are betting they can efficiently time their move away from it later.
This is my fourth post in the series called Is It Different This Time? Feel free to read the others, especially if you are ready to hit the panic button and sell your stocks and/or stock mutual funds.